THE  LIBRARY 

OF 

THE  UNIVERSITY 

OF  CALIFORNIA 


GIFT  OF 

Professor 
W»  Leonard  Crum 


I 


/<s 


ACCOUNTS 

THEIR  CONSTRUCTION  AND  INTERPRETATION 


ACCOUNTS 

THEIR    CONSTRUCTION    AND 
INTERPRETATION 

FOR 

BUSINESS    MEN   AND 
STUDENTS    OF   AFFAIRS 


BY 

WILLIAM   MORSE  COLE,  A.M. 

Associate  Professor  of  Accounting  in  Harvard  University 


REVISED  AND  ENLARGED  EDITION 


HOUGHTON  MIFFLIN  COMPANY 

BOSTON  •  NEW  YORK  •  CHICAGO  •  DALLAS  •   SAN  FRANCISCO 


COPYRIGHT,   IQ08  AND   1915,   BY  WILLIAM   MORSK   COLS 


ALL   RIGHTS   RESERVED 


CAMBRIDGE   .   MASSACHUSETTS 
PRINTED   IN    THE   U.    S.   A. 


Add'l 


PREFACE   TO  THE    REVISED   AND 
ENLARGED   EDITION 

The  first  issue  of  this  book  was  brought  out  at  a  time  when  no 
general,  non-technical,  non-professional  treatise  on  accounting  had 
been  published.  The  author  had  then  been  giving  for  eight  years 
a  course  of  instruction  to  seniors  in  Harvard  College  on  the  prin- 
ciples of  accounting,  and  believed  that  many  business  men  and 
students  of  affairs  would  be  interested  to  see  briefly  but  compre- 
hensively how  accounts  are  constructed  and  interpreted.  The  au- 
thor did  not  at  that  time  believe  that  the  public  would  be  interested 
to  pursue  the  subject  further  than  over  the  ground  covered  by  the 
original  text.  Since  that  time  the  community  at  large  has  come  to 
realize  that  no  business  can  be  efficiently  conducted  without  ade- 
quate accounting,  and  that  no  one  can  form  a  correct  judgment 
about  pubhc  economic  affairs  without  both  publicity  for  those  affairs 
and  a  knowledge,  on  the  part  of  the  public,  of  the  method  of  inter- 
preting accounts.  The  wide  use  of  the  book,  both  among  business 
and  professional  men,  on  one  hand,  and  in  college  classes,  on  the 
other,  has  led  to  a  demand  for  further  treatment  of  some  subjects 
and  for  brief  treatment  of  some  new  subjects.  This  illustrates  the 
growth  of  public  interest  in  accounting  problems  and  methods. 

The  material  with  which  accounting  deals  is,  of  course,  abstract. 
To  most  persons  figures  are  but  very  vague  symbols  of  very  ab- 
stract things.  As  an  assistance  to  those  who  wish  to  apply  account- 
ing principles  to  concrete  cases,  a  number  of  problems  have  been 
worked  out  in  the  text.  These  should  show  both  the  method  of  ap- 
proach to  the  solution  of  problems  and  the  application  of  detailed 
method.^ 

Since  the  original  publication  of  this  book  many  puzzling  ac- 
counting problems  of  general  interest  have  come  for  solution  be- 
fore business  men  of  wide  experience  and  acumen,  have  then  been 
passed  upon  by  legislative  enactment,  and  have  been  finally  decided 
by  judicial  or  administrative  bodies.  Volumes  might  be  written  on 

^  It  is  thought  inadvisable  to  increase  the  bulk  and  the  cost  of  the  book,  for  those 
who  do  not  care  to  use  it  as  a  text  for  intensive  study, by  the  insertion  of  practice  prob- 
lems. Such  practice  problems  are  for  sale  as  a  separate  publication,  however,  by  the 
Harvard  University  Press,  Cambridge,  Massachusetts. 


249 


VI  PREFACE 

these  interesting  problems.  Except  for  the  professional  accountant 
or  the  lawyer,  however,  such  treatment  would  have  little  value 
beyond  showing  the  chaotic  state  of  the  official  mind  on  fun- 
damental accounting  principles.  The  fruitlessness,  for  the  un- 
trained student,  of  the  study  of  specific  public  cases  is  due  in  part 
to  the  fact  that  almost  every  such  case  is  complicated  by  legal, 
economic,  and  administrative  considerations  that  may,  wisely  or 
imwisely,  overweigh  the  sound  and  pure  accounting  policy.  Ac- 
counting is  nothing  but  subUmated  common  sense  applied  to  find- 
ing and  telling  the  truth  about  business.  So  many  traditions  have 
grown  up  about  figures  and  business  transactions,  however,  that 
sometimes  telling  the  technical  truth  would  mislead  the  reader  of 
accounts  (who  is  often  the  public  unfamiliar  with  accounting 
terms)  far  more  than  telling  a  technical  falsehood  that  would  be 
interpreted  in  such  a  way  as  to  yield  the  truth.  Courts  and  legisla- 
tive bodies  and  business  executives  are  in  the  main  nowadays  de- 
sirous of  having  the  truth  come  out  about  business;  but  since  truth 
lies  in  the  ear  of  the  hearer  as  much  as  in  the  mouth  of  the  speaker, 
and  truth-telling  consists  in  using  the  language  which  will  make  the 
listener  know  the  facts  —  even  though  the  speaker  must  change 
his  own  vocabulary  to  convey  the  truth,  —  many  decisions  have  vio- 
lated the  minor  truth,  that  might  be  misunderstood,  for  the  sake  of 
the  larger  truth  that  must  prevail.  Many  of  the  legal  decisions, 
moreover,  have  been  made  by  courts  unfamiliar  with  accounting 
analyses,  on  arguments  presented  by  lawyers  who  were  equally 
innocent  and  were  bent  on  winning  their  cases  rather  than  on 
establishing  abstract  accounting  principles.  The  legal  aspects  of 
accounting  are  consequently  chaotic,  and  they  must  remain  so  un- 
til a  sufficient  number  of  causes  celebres  have  lopped  off  the  growth 
of  false  doctrine.  The  widely  spreading  public  interest  in  account- 
ing is  sure  to  result  in  more  careful  consideration  by  courts  here- 
after not  only  of  specific  cases  where  policy  is  involved,  but  of  the 
integrity  of  abstract  principles  that  may  guide  in  future.  To-day 
a  legal  decision  not  overruled  may  be  found  on  each  side  of  almost 
every  accounting  problem.  The  discussion  of  principles  in  this 
book,  therefore,  is  based  on  fundamental  analyses  through  com- 
mon sense,  and  does  not  attempt  to  follow  the  mazes  of  contradic- 
tory policy  in  complex  concrete  cases. 


PREFACE  Vll 

The  reader  will  observe  that  much  attention  is  given  to  specific 
kinds  of  business.  The  author  believes  that  a  principle  can  best  be 
grasped  when  its  operation  is  observed  in  concrete  affairs.  A  certain 
knowledge  of  business  is  essential  to  an  understanding  of  accounts, 
and  therefore  the  illustrations  are  taken  from  businesses  with 
which  everyone  is  somewhat  familiar.  Every  student  of  affairs, 
moreover,  should  know  something  of  the  method  of  interpreting  the 
accounting  figures  reported  by  businesses  of  universal  interest. 
The  order  of  treatment  of  subjects  is  accommodated  to  these  facts. 
Few  principles  are  discussed  comprehensively  in  one  place.  Usu- 
ally a  subject  is  merely  opened,  possibly  without  even  a  hint  of 
its  complications,  when  it  is  first  mentioned.  Only  after  the  way 
has  been  prepared  by  discussion  of  other  subjects  or  of  certain  busi- 
ness facts  are  its  more  abstract  and  more  vital  aspects  shown.  A 
principle  may  therefore  appear  in  early  pages,  receive  amplifica- 
tion in  other  chapters  later,  reappear  in  a  special  appHcation,  and 
receive  final  treatment  only  near  the  end  of  the  book.  This  gives 
the  development  of  accounting  ideas  a  natural  sequence:  to  make 
the  book  convenient  for  reference  purposes,  an  especially  full  index 
is  provided. 

Cambridge,  Massachusetts 
January  9, 1915. 


CONTENTS 

^  I.   Introduction i 

PART   I.   THE   PRINCIPLES   OF   BOOKKEEPING 

II.  Debit  and  Credit 9 

III.  The  Fundamental  Books 15 

IV.  The  Significance  of  Particular  Accounts 21 

V.  The  Trial  Balance,  the  Statement,  and  the  Balance 

Sheet 36 

VI.  Labor-saving  Devices 57 

PART   II.  THE   PRINCIPLES   OF   ACCOUNTING 

VII.  The  Distinction  between  Capital  and  Revenue     .    .      83 

VIII.  The  General  Principles  of  Depreciation 95 

IX.   The  General  Characteristics  and  the  Interpretation 

OF  Balance  Sheets 109 

X.  The  General  Principles  of  Cost  Accounting.    ...    141 
XI.  The  Place  of  Statistics  in  Accounting 151 

XII.  The  Relation  of  Principal  and  Interest  in  Valua- 
tions   159 

XIII.  The  General  Principles  of  Capitalization     ....    203 

XIV.  Some  General  Principles    Illustrated  in    Railroad 

Accounting 221 

XV.  Accounting  in  Reorganizations 241 

XVI.   Some  General  Principles    Illustrated   in   Bank  Ac- 
counting     249 

XVII.   Some  General  Principles  Illustrated  in  Trust  Ac- 
counting     255 

XVIII.   Some  Peculiarities  of  Accounting  for  Insurance  and 

for  Life  Tenures 263 


X  CONTENTS 

XIX.   Some    General    Principles    Illustrated   in   Factory 

Accounting 270 

XX.   Some  General  Principles  Illustrated  in  Municipal 

Accounting 327 

XXI.  Some  Miscellaneous  Applications  of  General  Prin- 
ciples 

I.  The  Treatment  of  Commercial  Discounts 340 

II.  Tlie  Significance  of  Proprietorship  Profits 342 

III.  A  Basis  for  Consolidations 346 

XXII.   Settlements  — Trusteeship,  Partnership,  Bankruptcy  352 

XXIII.  Auditing 363 

APPENDICES 

A.  Additional  Forms  of  Books,  to  supplement  Part  I 

I,  Certain  Special  Forms  (for  books  described) 369 

II.  Certain  Special  Principal  Books  for  Particular  Needs     .     .  375 

III.  Certain  Common  Auxiliary  Books 396 

B.  Additional  Entries,  to  supplement  Part  I 

I.  Opening  the  Books  of  a  Corporation 401 

II.  Another  Method  of  Closing  Books 407 

C.  Single  Entry 410 

D.  Loose-Leaf  Systems 413 

E.  The  Treatment  of  Petty  Accounts  and  Petty  Items  .    .  415 

F.  Formulae 419 

INDEX 437 


ACCOUNTS 

THEIR   CONSTRUCTION   AND   INTERPRETATION 


ACCOUNTS 

THEIR  CONSTRUCTION   AND  INTER- 
PRETATION 

CHAPTER  ONE 

INTRODUCTION 

It  is  common  to  read  in  a  report  concerning  the  failure  or  suspen- 
sion of  a  business  house  or  corporation  that  not  until  experts  have 
been  at  work  upon  the  books  for  several  days  or  weeks  can  any  one 
learn  the  exact  state  of  assets,  liabilities,  or  loss.  The  frequency 
with  which  this  statement  is  made  naturally  suggests  a  causal  con- 
nection between  accounting  and  success.  The  connection  suggested 
will  be  found  on  examination  to  be  existent  in  a  large  proportion  of 
the  cases  of  business  failure. 

The  average  business  man  does  not  know  what  things  cost  him. 
The  head  of  the  manufacturing  department  of  one  of  the  large  con- 
solidations, commonly  called  "trusts,"  recently  remarked  that  be- 
fore consolidation  he  used  to  wonder  how  some  of  his  competitors 
could  afford  to  take  contracts  at  their  own  bids.  After  the  consolida- 
tion he  discovered  that  these  competitors  never  knew  even  approxi- 
mately the  cost  of  manufacturing  their  goods  and  often  took  con- 
tracts at  an  inevitable  loss  —  which  simply  happened  to  be  made 
good  by  large  profits  on  other  contracts.  This  is  typical  for  much  of 
our  American  business,  but  good  accounting  can  forestall  many  of 
the  elements  of  bad  luck  and  show  just  where  lies  the  good.  In  view 
of  the  remarkable  success  of  American  trade  in  spite  of  much  bad 
accounting,  —  or,  rather,  in  spite  of  no  accounting  at  all  in  thousands 
of  establishments,  —  one  is  forced  to  anticipate  phenomenal  success 
when  good  accounting  shall  become  general. 

Perhaps  no  field  in  connection  with  business  activity  in  America 
has  advanced  so  little  in  the  last  twenty- five  years  as  accounting. 
The  changes  in  the  economics  of  industry  have  been  marvelous* 


2  ACCOUNTS 

theoretical  science  has  been  applied  practically,  social  forces  have 
been  utilized,  and  the  spirit  of  organization  has  taken  hold  of  every 
element  to  bring  out  its  maximum  utility.  Yet  until  a  few  years  ago 
accounting  had  remained  well-nigh  stationary.  Not  many  years  ago, 
most  businesses  were  conducted  on  a  small  scale.  In  both  manu- 
facturing and  commerce,  certain  direct  costs  were  involved  in  raw 
material  and  stock,  in  rent,  service,  insurance,  interest,  and  risk ;  and 
the  return  or  income  was  equally  simple  in  the  form  of  payment  for 
goods  sold.  Few  business  houses  attempted  more  than  one  line  of 
activity:  they  bought  a  few  raw  materials,  which  they  converted 
by  comparatively  few  processes  into  staple  lines  of  goods,  or  they 
bought  finished  goods,  which  they  distributed  by  comparatively 
simple  methods.  For  this  sort  of  thing  simple  devices  for  subtracting 
cost  from  return,  in  order  to  show  profit,  were  sufficient.  With  the 
growth  of  industry,  involving  competition  so  keen  that  profit  must 
be  figured  with  extreme  closeness,  and  with  the  advance  of  organi- 
zation, such  that  one  house  manufactures  not  only  its  principal 
product,  and  its  numerous  by-products,  but  perhaps  hundreds  of 
inferior  products  as  supplies  for  its  own  consumption,  the  old  methods 
of  accounting  have  been  found  utterly  inadequate.  The  greater  the 
variety  of  work  attempted,  the  more  easily  does  any  leakage  or  waste 
pass  unnoticed,  and  yet  the  more  does  it  hamper  in  competition.  In 
the  old  days,  when  each  firm  bought  its  supplies  and  added  but  one 
step  to  the  manufacturing  or  distributing  process,  —  with  a  consider- 
able margin  of  profit,  —  a  slight  leakage  was  not  of  serious  import : 
it  affected  the  profits  of  one  firm,  but  it  did  not  affect  the  next  firm 
concerned  in  the  general  process. 

This  may  be  well  illustrated,  perhaps,  by  the  time-table  of  a 
through  railroad  train,  running  over  several  lines.  The  schedule  is 
arranged  to  allow  leeway  of  several  minutes  at  each  junction  point. 
Such  a  train  may  lose  time  on  every  section  of  road  except  the  last, 
and  yet  arrive  at  its  destination  on  time.  The  loss  on  each  section 
simply  reduces  the  wait  at  the  next  junction  point.  Yet  a  train 
booked  to  make  absolutely  close  time  for  its  full  run  can  lose  no  time 
at  any  point  without  some  failure  at  its  destination.  Business  used  to 
be  conducted  on  the  fashion  of  the  leeway  time-table.  The  margin 
or  leeway  was  the  profit  of  the  middleman  —  which  might  be  in- 
creased or  reduced  without  affecting  the  next  producer.    Modern 


INTRODUCTION  3 

business  is  conducted  practically  on  a  close  schedule  —  especially 
when  all  the  branches  of  an  industry  are  conducted  under  one  con- 
trol. Nowadays,  in  large  industries  the  cost  of  a  finished  product  in 
one  department  is  ipso  jacto  the  cost  of  raw  material  in  the  next.  No 
leeway  is  allowed.  Any  leakage  suffered  at  any  point  is  concentrated 
in  a  magnified  loss  at  the  end. 

When  business  was  simple,  but  few  alternatives  in  methods  were 
possible;  but  now  that  the  complications  are  great,  the  possible 
alternatives  of  process  and  of  organization  are  many.  How  can 
one  learn  the  comparative  economy  of  two  processes  or  of  two  sys- 
tems of  organization  except  by  very  elaborate  and  detailed  records 
of  results?  And  the  greater  the  number  of  alternatives,  the  more 
detailed  must  be  the  records. 

It  is  the  merest  commonplace  to  say  that,  if  a  business  house  is 
conducting  four  lines  of  operation  of  which  one  causes  loss  while  the 
others  are  profitable,  the  manager  would  be  foolish  not  to  drop  the 
bad  one  and  push  the  most  profitable  of  the  three.  Yet  how  shall 
he  know  whether  any  fails  or  any  is  more  profitable  than  the  others? 
Surely  not  by  simply  finding  his  total  profit  or  loss  for  the  year.  It 
is  quite  as  important  for  future  guidance  to  know  the  comparative 
profitableness  of  various  enterprises  as  it  is  to  know  their  combined 
earnings  or  cost. 

An  illustration  of  comparatively  simple  industry  is  mining.  In  one 
day  the  expenditures  at  a  mine  may  include  the  following :  wages 
for  digging  and  raising  ore,  for  loading  and  transporting  ore,  for  cut- 
ting a  new  gallery,  for  sinking  a  new  shaft,  for  pumping  water,  for 
repairing  a  hoisting  engine ;  payment  for  a  new  boiler  for  increased 
power;  taxes  upon  mineral  land  bought  but  not  yet  worked.  How 
are  these  expenditures  related  to  profits,  and  how  shall  we  determine 
profits  for  the  day  ?  A  part  of  the  expenditure  —  digging,  raising, 
loading,  and  transporting  ore  —  was  direct  cost  of  producing  that 
day's  ore,  and,  being  entirely  exhausted  once  for  all,  must  be  paid  for 
ultimately  from  the  value  of  the  ore  to-day  extracted.  The  cost  of 
cutting  a  new  level  has  not  entered  into  the  cost  of  to-day's  ore, 
but  may  enter  into  the  cost  of  getting  next  month's  ore,  and  next 
year's  ore;  and  yet  back  in  the  past  the  cost  of  cutting  some  level 
which  was  worked  to-day  was  a  part  of  the  cost  of  to-day's  ore.  Do 
the  two  costs  correspond?  If  not,  how  far  do  they  fail  to  correspond? 


4  ACCOUNTS 

The  cost  of  sinking  a  shaft  to-day  may  contribute  to  next  year's  ore, 
and  that  of  ten  years  hence,  or  even  that  which  the  grandchildren  of 
the  present  owner  may  mine.  How  far  is  it  cost  to-day,  or  how  far 
is  it  a  fair  measure  of  the  cost  of  to-day's  ore  ?  The  cost  of  pumping 
out  water  after  a  freshet  is,  in  a  sense,  no  part  of  the  direct  cost  of  any 
ore,  but  is  a  direct  loss.  It  may  be  due  to  defective  engineering  when 
the  mine  was  opened.  How  shall  we  treat  it  in  relation  to  to-day's 
profit?  The  repairs  on  the  hoisting  engine  are  not  related  directly 
to  to-day's  ore,  but  belong  to  the  past.  Taxes  on  land  not  yet  used 
may  have  no  relation  even  to  the  early  future.  How  shall  we  treat 
them? 

Innumerable  questions  of  this  sort  must  be  answered  before 
profits  for  any  year  can  be  determined.  This,  moreover,  is  but  a  part 
of  the  problem  of  successful  accounting.  Total  profit  is  not  enough 
to  know.  No  one  would  wish  to  work  twenty  galleries  if  nineteen 
would  be  more  profitable.  How  shall  one  know  whether  each  of  the 
twenty  galleries  is  profitable  ?  Finally,  there  are  many  possible  alter- 
natives of  method.  What  ore  is  better  thrown  away  than  worked  ? 
Is  it  cheaper  to  sell  ore  than  to  smelt  it  ?  Is  it  cheaper  to  transport  it 
to  a  distance  than  to  smelt  it  at  the  mine  ?  Nothing  but  careful 
accounting  can  furnish  bases  for  answering  such  questions. 

It  is  easy  to  sneer  at  statistics  as  too  dry,  both  in  the  making  and 
in  the  reading,  to  interest  the  man  of  active  temperament ;  but  every 
business  man  of  wide  experience  knows  that  often,  in  the  choice  of  a 
basis  for  business  operations,  the  difference  between  statistics  and 
guesswork  is  the  difference  between  success  and  failure.  It  is  true 
that  the  accountant  is  merely  the  historian  of  business;  and  as  the 
historian  of  deeds  is  less  important  than  the  doer,  so  the  rank  of  the 
accountant  in  business  is  comparatively  low.  Yet  often,  as  the  his- 
torian sees  more  deeply  into  politics  than  the  busy  politician  or 
statesman,  so  the  accountant  sees  more  deeply  into  business  trans- 
actions than  the  manager  himself.  A  statesman  who  disregards 
history  makes  himself  ridiculous ;  a  business  man  who  cares  nothing 
for  accounts  often  makes  himself  not  only  ridiculous  but  a  pauper. 

The  processes  of  record  bookkeeping  are  almost  as  simple  as  pri- 
mary arithmetic ;  but  what  in  this  book  we  shall  call  accounting  com- 
prehends far  other  elements.  Accounting,  in  the  sense  in  which  it  is 
used  here,  is  scientific  analysis  and  record  of  business  transactions. 


INTRODUCTION 


S 


It  attempts  to  tell  about  every  transaction  everything  that  can  be  of 
service  when  known.  It  attempts  to  show  the  result  of  every  eflfort, 
the  cost  of  every  return.  Only  by  its  aid  can  satisfactory  comparison 
be  made  of  different  enterprises  and  different  methods.  This  book 
is  an  attempt  to  set  forth  in  simple  form  the  main  principles  which 
must  govern  any  attempt  at  accounting.  Since  scientific  analysis  of 
business  transactions  is  hardly  serviceable  until  recorded  in  intelli- 
gible form,  the  fundamental  principles  of  record  bookkeeping  will 
also  be  briefly  stated  and  illustrated.  No  attempt  will  be  made  to 
discuss  or  illustrate  all  even  of  the  common  forms  of  bookkeeping, 
nor  will  the  shortest  forms  be  necessarily  chosen,  or  even  mentioned ; 
indeed,  for  the  purposes  of  this  book,  the  longer  and  more  old- 
fashioned  forms  will  often  prove  more  serviceable.  The  aim  here  is 
not  to  show  short-cuts  and  bookkeeping- made- easy,  but  thorough 
discussion  of  principles,  so  that  the  student  of  the  book  shall  be 
master  of  something  better  than  rules  of  thumb,  and  shall  be  able  to 
judge  for  himself  what  short-cuts  will  serve  his  purpose.  The  book 
is  intended  to  be  comprehensive  for  principles,^  but  is  not  meant  for 
an  encyclopaedia  of  bookkeeping  forms  and  practice.  Many  excellent 
manuals  of  such  sort  are  on  the  market.  For  the  convenience  of  those 
who  are  already  familiar  not  only  with  bookkeeping  practice  but 
also  with  the  philosophical  basis  upon  which  it  rests,  these  matters 
are  discussed  by  themselves  in  Part  I.  Part  II  is  devoted  entirely  to 
the  analytical  side  of  accounting.  The  later  chapters  of  Part  II 
attempt  to  make  general  principles  more  concrete  by  applying  them 
to  the  problems  of  different  lines  of  business  in  which  they  may  be 
best  illustrated  —  without,  however,  entering  into  technical  details  ol 
any  business. 

1  Indeed,  it  may  be  said  that  there  are  but  three  principles  of  bookkeeping  —  the 
nature  of  debit  and  credit,  the  distinction  between  real  and  nominal  accounts,  and 
the  use  of  the  special  column.  The  art  of  bookkeeping  is  to  apply  these  principles  in 
their  numerous  ramifications. 


PART    ONE 
THE   PRINCIPLES   OF   BOOKKEEPING 


CHAPTER  TWO 

DEBIT  AND   CREDIT 

At  the  basis  of  all  accounting  is  the  distinction  between  debit  and 
credit.  In  simple  transactions  of  sale  and  payment,  few  persons 
find  difficulty  in  deciding  which  is  which ;  but  in  many  complicated 
transactions,  involving  rights  and  claims,  confusion  easily  arises. 

Debit  (from  the  Latin  debet,  he  owes)  means,  in  accounting,  not 
merely  that  something  is  owed,  but  that  a  definite  person  (or  per- 
sonified property  or  force)  is  responsible  for  some  value.  All  three 
elements  of  this  meaning  are  important:  first,  the  responsibility 
attaches  to  a  definite  person  or  thing  named ;  second,  the  responsi- 
bihty  is  not  necessarily  a  debt,  but  often  may  be  acquitted  in  some 
way  other  than  by  payment ;  third,  the  responsibility  has  its  origin 
in  a  definite  consideration  of  value.  The  importance  of  these  three 
elements  will  appear  later. 

Credit  (from  the  Latin  credit,  he  intrusts)  means  the  converse  of 
debit,  i,  e.,  a  definite  person  (or  personified  property  or  force)  has 
granted  some  definite  value.  This  again  involves  the  same  three 
elements :  the  grant  was  made  by  a  definite  person  or  thing  named ; 
it  may  be  in  an  intangible  form,  —  in  a  claim,  in  the  surrender  of  a 
right,  or  in  the  discharge  of  a  responsibility ;  it  must  be  susceptible  of 
statement  in  dollars  and  cents.  That  credits  do  not  always  represent 
debts  is  shown  by  the  fact  that  capital  stock  commonly  appears  on 
the  credit  side  of  corporation  reports.  The  corporation  is  account- 
able for  the  capital  stock,  but  it  does  not,  in  the  ordinary  sense  of  the 
word,  owe  anything  upon  it. 

A  few  illustrations  will  be  necessary  to  make  clear  just  when  an 
account  should  be  debited  and  when  credited.  The  record  ''  J.  Jones, 
Dr.,  $1000,"  means  that  by  the  business  house  upon  whose  books 
it  occurs  J.  Jones  is  held  responsible  for  a  thousand  dollars ;  but  with- 
out further  explanation  we  cannot  tell  whether  Jones  owes  a  thou- 
sand dollars  or  is  merely  to  account  for  his  use  of  a  thousand  dollars 
which  has  been  intrusted  to  him.  So  far  as  mere  debit  and  credit  are 
concerned,  the  two  types  of  responsibility  aiQ  identical;  and  hence 


lO  ACCOUNTS 

some  detailed  record  of  the  transaction  other  than  debit  and  credit 
is  required.  It  is  to  be  noted,  however,  that  each  entry  may  be  in- 
dependent of  every  other.  When  Jones  discharges  his  responsibility, 
either  by  paying  the  debt  or  by  performing  the  service,  he  must  be 
credited,  for  in  either  case  he  will  have  intrusted  or  granted  value  to 
the  firm  with  which  the  transaction  occurs.  Yet  the  bookkeeper 
does  not  need  to  know,  before  making  the  entry,  whether  Jones  had 
been  previously  debited  for  his  responsibility.  The  credit  to  Jones  is 
made  at  the  time  that  the  grant  of  value  is  made  by  him,  whether 
he  has  been  previously  paid  or  not ;  and  the  debit  to  him  is  made  at 
the  time  that  he  is  paid,  whether  he  has  previously  granted  the  value 
in  return  or  not.  If  entries  are  accurately  made  when  the  transac- 
tions occur,  each  may  be  absolutely  independent  of  every  other,  and 
the  whole  truth  may  be  learned  at  any  time  by  taking  them  in 
combination.  The  whole  matter  may  be  briefly  summarized  in  this 
form:  when  an  account  takes  a  responsibility  (that  is,  becomes 
accountable  for  something),  debit  it;  and  when  an  account  puts 
a  responsibility  somewhere  else  (which  is  sometimes  getting  rid  of 
accountability  previously  taken),  credit  it. 

This  emphasis  upon  responsibility  may  seem  for  the  moment  some- 
what unnecessary,  but  in  some  cases  only  by  reference  to  responsi- 
bility can  we  determine  whether  an  account  should  be  debited  or 
credited.  For  example,  a  common  means  of  acquitting  responsibility 
is  drafts.  The  bookkeeping  entries  made  in  connection  with  a  draft 
well  illustrate  the  philosophy  of  debit  and  credit.  We  will  assume 
that  Jones  is  responsible  to  you,  the  reader,  for  $1000.  We  will 
assume,  too,  that  you  owe  your  broker  $1000.  It  may  happen  that 
the  broker  owes  Jones.  In  that  case,  these  various  responsibilities 
will  show  on  the  various  books  as  follows :  — 

Reader's  books  :  Jones's  books  :  Broker's  books : 

J.  Jones,    Dr.  $1000  Broker,   Dr.  $1000  Reader,  Dr.  $1000 

Broker,      Cr.  $1000  Reader,  Cr.  $1000  Jones,      Cr.  $1000 

Now  Jones  draws  a  draft  on  the  broker  ordering  him  to  pay  you 
$1000,  and  the  broker,  by  agreement  with  you,  pays  that  draft  by 
canceling  your  debt  to  him.  In  such  a  case,  you  have  received  nothing 
and  have  paid  nothing.  Upon  your  books  you  debit  the  broker  and 
credit  Jones,  —  on  the  ground  that  the  broker  is  responsible  for 
keeping  the  money  that  he  was  ordered  to  pay  you,  and  that  Jones 


DEBIT  AND   CREDIT  II 

has  got  rid  of  his  responsibility  to  pay  you.  If  the  broker  were  not 
already  credited  with  what  you  owed  him,  his  responsibility  would 
now  show  as  requiring  to  be  acquitted  in  the  future;  but  as  such 
credit  already  appears  on  your  books,  the  two  entries  read  in  com- 
bination show  that  the  responsibihty  just  now  taken  was  discharged 
before  it  was  taken,  and  that  you  are  square  with  the  broker.  If 
Jones  were  not  already  debited  on  your  books,  he  would  now  appear 
to  be  your  creditor  for  $1000 ;  but  the  two  entries  read  in  combina- 
tion now  show  that  you  are  square  with  Jones. 

No  other  rule  but  that  of  responsibility  is  sure  to  serve  the  inex- 
perienced in  determining  whether  to  debit  or  to  credit  an  account. 
Sometimes  a  rule  is  given  as  follows:  ''Debit  destination  and  credit 
source."  This  rule  serves  in  simple  transactions,  but  sometimes  two 
evidences  of  value — or  none  at  all  —  are  involved,  and  the  source  of 
one  is  the  destination  of  the  other ;  so  that  for  the  inexperienced  the 
rule  either  gives  confusion  or  recommends  two  entries  which  would 
counteract  each  other. 

In  every  case  a  responsibility  can  be  traced.  Sometimes,  however, 
the  responsibility  is  such  as  often  we  have  in  mind  when  we  use  an 
expression  like  "The  weather  is  responsible  for  the  delay."  It  is 
customary  in  business  to  debit  losses  or  expenses  to  particular  ac- 
counts which  represent  not  persons  or  other  tangible  things,  but, 
rather,  mere  forces ;  for  it  is  not  enough  to  know  debts  and  property, 
— we  wish  to  know  the  sources  or  causes  of  gain  or  loss.  When  we 
pay  interest,  therefore,  we  should  debit  Interest  Account  —  the  debit 
standing  for  loss  or  expense ;  for  interest  is  responsible  for  the  loss, 
—  just  as  bad  weather  may  be  responsible  for  delay.  If  it  were  not 
for  that  force  in  business  which  we  call  interest,  the  loss  would  not 
have  been  suffered :  hence  Interest  Account  is  responsible.  Interest 
Account  is  credited  when  interest  is  earned.  The  use  here  of  a 
credit,  too,  is  consistent  with  our  general  principle :  we  debit  for  a 
responsibility  taken  by  an  account,  and  we  credit  for  a  responsibility 
conferred  by  an  account ;  and  here  that  force  which  we  call  interest 
has  earned  for  the  business,  has  granted  to  the  business,  a  profit 
which  the  firm  is  now  accountable  for. 

We  have  already  noted  two  kinds  of  accounts,  —  with  persons  and 
with  forces.  A  third  kind,  with  property,  shows  the  same  relations 
with  debit  and  credit.   In  all  careful  accounting,  record  is  kept  of 


12  ACCOUNTS 

cash  on  hand,  notes,  merchandise,  real  estate,  and  other  similar 
tangible  property.  At  first  thought,  the  application  of  debit  and 
credit  to  these  seems  arbitrary,  for  responsibility  seems  hardly  to 
attach  to  such  accounts.  A  reminder  of  what  these  accounts  stand 
for,  however,  shows  the  philosophical  basis  of  their  treatment. 
Every  one  knows  that  the  purpose  of  a  cash  account  is  to  show  what 
cash  ought  to  be  on  hand.  The  cash  balance  on  the  books,  then,  is  a 
liability  of  the  cashier,  or  cash-drawer,  or  bank,  or  what  not.  No 
respectable  bookkeeper  makes  up  his  cash  account  from  his  cash- 
drawer:  on  the  contrary,  he  fixes  the  responsibiUty  of  the  cash- 
drawer  by  the  cash  account.  Thus  the  cash  account  represents  quite 
as  truly  a  responsibihty  as  does  an  account  with  an  outside  firm; 
only,  in  this  case,  the  responsibihty  attaches  not  to  an  outsider  but  to 
a  department  or  agent  of  the  business  itself.  The  same  thing  is  true 
of  a  note  account,  a  merchandise  account,  a  real-estate  account,  and 
the  Hke.  In  the  case  of  real  estate,  for  example,  an  account  enti- 
tled "Store,  No.  6000  Six  Hundredth  Street,"  would  represent  the 
property  as  a  depositary  of  so  much  value.  When  the  store  was 
bought,  the  account  should  have  been  debited  —  as  responsible  for 
the  value,  a  sort  of  depositary.  If,  now,  half  of  the  store  be  sold, 
the  account  should  be  credited  with  the  value  of  that  half,  the  ac- 
count being  acquitted  of  so  much  of  its  responsibihty  as  a  depositary. 
I  We  have,  then,  three  kinds  of  accounts,  —  those  representing 
I  persons,  those  representing  forces,  and  those  representing  property. 
Now,  an  interesting  relation  exists  between  the  last  two  classes.  An 
account  representing  a  force  is  debited  when  responsible  for  a  loss : 
an  account  representing  property  is  debited  for  property  received. 
Property  received  and  loss  suffered,  therefore,  are  treated  as  if  exactly 
aUke,  although  in  reality  two  things  could  hardly  be  more  unlike. 
This  shows  the  absolute  necessity  of  knowing  just  what  each  account 
represents.  For  example,  let  us  suppose  that  we  buy  ten  thousand 
tons  of  ice,  and  enter  it  to  the  debit  of  a  property  account  called 
**  Silver  Pond  Ice."  Perhaps  tramps  set  fire  to  the  ice-house,  and  the 
ice,  which  is  uninsured,  is  melted  by  the  fire  and  by  the  subsequent 
exposure.  Must  we  necessarily  make  any  entry  upon  our  books  to 
show  this  loss?  We  might  debit  Loss  and  Gain  Account  as  respon- 
sible, and  credit  " Silver  Pond  Ice"  as  acquitted  of  its  responsibihty; 
but  this  is  hardly  necessary.  If  we  merely  change  the  classification 


DEBIT  AND   CREDIT  I3 

of  our  Silver  Pond  Ice  account,  considering  it  now  as  an  account 
representing  a  force  —  in  this  case  loss  by  fire  —  rather  than  property, 
our  books  are  still  correct,  and  our  principle  of  debit  and  credit  has 
been  satisfied.  The  difference  is  simply  that  at  the  close  of  the  year, 
or  quarter,  or  other  period  for  determining  assets  or  profits,  we  must 
take  care  that  the  Silver  Pond  Ice  Account  is  included  in  the  schedule 
of  losses  and  not  in  that  of  property.  If  you  send  an  errand  boy  with 
a  hundred  dollars,  with  fifty  of  which  he  is  to  buy  merchandise  and 
the  other  fifty  of  which  he  is  to  contribute  for  you  to  a  relief  fund  for 
starving  people  in  China,  his  responsibility  is  as  fully  discharged  by 
the  receipt  for  the  relief  fund  as  by  the  merchandise,  though  one 
from  the  business  point  of  view  may  represent  pure  loss  and  the  other 
represents  property.  Both  expenditures  of  fifty  dollars  are  debited  — 
one  perhaps  to  Charity  Account,  which  satisfies  accountabiHty,  and 
the  other  perhaps  to  Merchandise  Account,  which  shows  what  you 
may  hold  your  warehouse  liable  for.  The  purpose  of  debit  and  credit  '^ 
entries  is  solely  to  record  responsibilities,  and  responsibilities  may  be 
discharged  in  so  many  ways  that  care  must  always  be  taken  to  dis-, 
tinguish  between  those  that  show  liability  and  those  that  show  merely 
accountability. 

Out  of  the  view  of  debit  and  credit  as  it  has  just  been  given  has 
developed  the  double-entry  system  of  bookkeeping.  It  is  obvious 
that  a  business  responsibility  cannot  spring  from  nothing.  Every- 
thing must  have  a  source  or  cause.  If  money,  or  any  other  valuable 
thing,  has  come  to  a  business,  it  is  obvious  that  but  two  explanations 
are  possible:  either  some  one  has  conferred  something  upon  the 
firm  (by  the  payment  of  debt,  by  loan,  or  by  sale  on  trust),  or  else 
profit  has  been  made.  To  debit  the  cash  or  other  property  account  is 
not  enough,  then ;  for  if  one  wishes  one's  books  to  show  all  that  they 
can  show,  one  must  record  the  source  of  that  value  —  either  in  a 
personal  account  or  in  an  account  representing  an  earning  force, 
such  as  interest,  rental,  or  what  not.  So,  too,  if  property  is  sent 
away,  some  cause  must  be  behind  the  outgo,  —  a  loan,  a  payment 
for  debt,  a  purchase  of  other  property,  or  a  loss  on  account  of  some 
force.  In  that  case  some  property  account  must  be  credited,  as 
always  happens  when  a  property  account  has  given  up  a  part  of  the 
value  for  which  it  has  been  held  responsible,  and  some  other  account 
must  be  debited  to  show  what  has  taken  the  responsibility.    It  is 


14  ACCOUNTS 

inconceivable  in  strict  business  that  property  should  be  either  re- 
ceived or  sent  away,  or  that  profit  or  loss  should  be  made,  without 
an  assignable  responsibility  conferred  on  one  hand  and  taken  on  the 
other,  and  all  good  bookkeeping  shows  both  sides  of  each  transac- 
tion. This  is  all  that  is  meant  by  double  entry.  A  debit  or  a  credit 
can  be  but  half  of  any  transaction ;  for  whether  it  records  responsi- 
bility for  property,  claim,  profit,  or  loss,  it  involves  an  explanation, 
and  that  explanation  must  show  where  that  responsibility  came 
from.  Perhaps  only  an  illustration  can  embody  the  whole  principle. 
It  seems  correct  and  sufficient  to  debit  cash  for  the  finding  of  an 
unclaimed  and  unexplained  hundred-dollar  bill  on  the  office  floor. 
Nothing  seems  to  be  involved.  There  is  no  assignable  source  for  the 
profit.  Yet  that  very  fact  is  what  the  books  should  show.  An  account 
must  be  opened  for  that  sort  of  thing  —  perhaps  called  "  Chance," 
or  ''Luck,"  or  "  Cash  Variations."  Ordinarily  such  things  would  be 
carried  to  the  so-called  "profit  and  loss"  or  the  "loss  and  gain" 
account,  where,  at  the  end  of  the  year,  they  are  lumped  with  other 
gains  or  losses.  Here,  when  property  account.  Cash,  is  debited,  an 
account  representing  a  force,  as  Loss  and  Gain,  should  be  credited, 
to  explain  the  property  change  —  on  the  principle  that  no  change 
could  have  taken  place  in  the  property  account  without  adequate 
cause.  The  entry  would  be,  then,  "Cash,  Dr.,  to  Loss  and  Gain, 
Cr."  So,  too,  when  a  loss  is  suffered,  a  cause  is  bound  to  exist,  and 
that  cause  should  be  recorded.  If  a  note  is  discounted,  the  discount 
is  taken  from  the  face  of  the  note  and  the  effect  of  the  force  that  pro- 
duces it  is  registered  as  a  debit  to  Interest  (or  Discount).  Cash  is  here 
credited,  of  course ;  for  as  cash  has  been  properly  lost,  the  cashier, 
or  cash-drawer,  is  by  so  much  acquitted  of  responsibility.  The  entry 
is:  "Interest,  Dr.,  to  Cash,  Cr." 

Double  entry,  then,  means  not  that  each  transaction  is  entered 
twice,  but  only  that  each  transaction  is  entered  from  a  double  point 
of  view  —  cause  and  effect,  or  source  and  destination.  As  will  be 
shown  later,  this  does  not  involve  double  labor  on  the  part  of  the 
bookkeeper,  for  by  certain  devices,  special  columns  and  special  pages 
and  special  books,  extra  work  in  recording  by  double  entry  is  almost 
wholly  avoided. 


CHAPTER  THREE 

THE  FUNDAMENTAL  BOOKS 

Scientific  bookkeeping  is  possible  even  with  very  few  books.  Tiie 
use  of  great  numbers  of  books  in  large  counting-houses  has  its  origin 
not  so  much  in  the  method  of  bookkeeping  as  in  the  magnitude  of  the 
business  recorded.  To  be  sure,  the  books  in  such  a  counting-house 
are  of  many  sorts  and  are  complicated  in  form,  but  the  variations 
from  simple  types  have  arisen  hardly  at  all  from  a  desire  for  better 
accounting,  but  chiefly  from  a  desire  to  make  accounting  more  e<:o- 
nomical.  Probably  no  accounting  is  conducted  anywhere  that  could 
not  be  conducted  with  equal  correctness  by  means  of  the  old-fash- 
ioned set  of  three  simple  books  —  day-book,  journal,  and  ledger. 
In  many  cases,  however,  such  accounting  would  require  by  old 
methods  one  hundred  bookkeepers  where  now  ten  suffice.  No 
attempt  will  be  made  in  this  book  to  do  more  in  the  matter  of  mere 
record  bookkeeping  than  to  show  the  principles  of  simple  books  and 
to  explain  a  few  of  the  most  common  types  or  systems  of  abbrevia- 
tion. 

The  most  obvious  duty  of  a  bookkeeper  is  to  record  each  trans- 
action in  such  detail  that  at  any  time  in  the  future  its  history  can  be 
determined  without  shadow  of  doubt. 

The  simplest  type  of  business  record-book  is  the  old-fashioned 
day-book  —  practically  a  diary  —  which  has  now  been  supplanted. 
Its  principle,  however,  is  enduring,  and  must  be  understood.  In  it 
each  transaction  is  given  a  paragraph,  which  tells  all  detail  that  can 
possibly  be  of  use  for  future  reference.  For  example,  when  goods 
are  shipped,  not  only  the  amount,  quality,  and  price  should  be  given, 
but,  where  possible,  case-number,  or  car-number,  or  other  means 
of  identification.  When  payment  is  made  by  a  note,  the  record  should 
show  for  future  reference  a  number  of  details  sufficient  to  identify 
that  note,  such  as  its  date,  time  to  run,  payee,  amount,  and  the  like. 

This  does  not  mean,  however,  that  dupHcation  of  record  is  de- 
sirable.  When  all  notes  are  recorded  in  a  separate  register,  as  in 
most  counting  rooms  nowadays,  the  day-book  entry  needs  to  record 


i6 


ACCOUNTS 


for  identification  only  the  number  of  the  note,  leaving  the  other 
book  to  furnish  the  details.  So,  too,  when,  as  in  most  manufacturing 
concerns  to-day,  an  order-book  is  kept,  details  of  shipments  may 
be  left  to  that  book,  the  day-book  presenting  for  identification  only 
the  number  of  the  order. 
An  old-fashioned  day-book  entry  looks  like  this: 


August  lo 

Sold  James  Madison,  on  30  days'  time 

8  M,  ft.  spruce  lumber                                   @  15 
3  M.  clear  cedar  shingles                                       4 
B.  &  M.  R.  R.  #26,341 

$120 
12 

00 
00 

132 

or  this: 

August  12 

Received  of  James  Madison  his  note,  dated  8/10,  on 

30  ds.,  in  payment  of  his  invoice  of  8/10 

132 

00 


00 


This  day-book  is  of  great  value  as  legal  evidence,  for  it  is  an 
original  document.  It  is  supposed  to  be  a  faithful  record,  v^^ritten 
at  the  time  of  the  transaction.  Nothing  but  receipts  or  other  signed 
vouchers  can  be  better  evidence,  and  it  is  for  this  reason  that  the 
day-book  is  of  utmost  importance.  Such  a  book  should  be  abso- 
lutely free  from  erasures  in  any  vital  figure,  for  each  erasure  testifies 
to  the  deficiency  of  the  book  as  an  original  document.  Errors  will 
creep  in,  of  course,  but  they  should  be  corrected  by  counter- entries. 
For  example,  an  error  in  price  may  be  counterbalanced  by  another 
entry  charging  or  crediting  the  difference  and  indicating  distinctly 
which  entry  it  is  designed  to  correct.  The  original  entry  should  be 
marked  *' Erroneous,"  with  an  indication  where  the  correction  is  to 
be  found ;  for  otherwise  it  fails  to  tell  the  truth.  If  the  error  has  been 
made  by  debiting  the  wrong  man,  correction  may  be  made  by  credit- 
ing him  and  debiting  the  right  man.  (Bookkeeping  never  works  by 
subtraction:  it  produces  the  desired  result  by  adding  to  the  contrary 
side.)  Since  all  other  books  contain  theoretically  mere  transfers 
from  the  day-book,  they  are  of  comparatively  little  importance  as 
evidence.  It  is  only  in  so  far  as  it  can  be  shown  that  the  other  books 
are  correct  transcripts  of  the  day-book,  or  are  themselves  original 
documents,  that  they  are  valuable  in  court. 

In  actual  practice,  one  common  kind  of  transaction  practically 
never  goes  upon  the  day-book.  As  it  is  convenient  to  keep  cash  items 


THE   FUNDAMENTAL  BOOKS  I7 

by  themselves,  so  that  the  record  of  cash  may  be  compared  with  the 
actual  cash  on  hand,  cash  is  usually  entered  in  a  special  cash-book 
only.  This  in  its  simplest  form  is  nothing  but  a  part  of  the  day- 
book containing  items  specially  selected  for  a  particular  purpose.  It 
will  be  described  in  another  chapter. 

It  is  obvious  that  for  a  business  man  to  run  over  innumerable 
pages  of  his  day-book,  and  pick  out  an  item  here  and  an  item  there, 
in  order  to  determine  (for  example)  how  much  interest  he  has  paid 
in  the  last  few  months,  would  be  not  only  a  tedious  task,  but  also  one 
which  by  a  slight  oversight  might  utterly  fail  of  its  purpose.  It  is 
very  easy,  when  running  the  eye  over  many  pages,  to  miss  an  item 
which  is  for  most  purposes  unimportant  but  may  be  extremely  im- 
portant for  the  matter  in  hand.  For  purposes  of  convenience,  in 
order  to  classify  all  items  so  that  each  shall  appear  where  it  can 
easily  be  found,  all  business  houses  keep  what  is  called  a  ledger. 
This  ledger  is  really  a  sort  of  combination  of  index  and  figurative  set 
of  pigeon-holes.  It  classifies  and  pigeon-holes  much  desirable  in- 
formation, and  what  it  does  not  fully  pigeon-hole  it  indexes.  In  a 
ledger,  definite  space  (a  page,  or  more,  or  less)  is  assigned  to  each 
person,  or  force,  or  kind  of  property,  with  which  it  is  worth  while  to 
keep  an  account,  and  in  that  space,  in  parallel  columns,  are  written, 
without  detail  but  with  index  references,  all  debits  or  credits  relating 
to  that  account.  Simple  addition  shows  the  total  debit  or  credit  for 
each  account  at  any  time.  The  purpose  of  the  ledger  is  simply  to 
rearrange  the  items  of  the  day-book  so  that,  whereas  they  stand  in 
the  original  book  arranged  by  transactions,  they  stand  in  the  ledger 
classified  according  to  the  persons,  forces,  or  property  concerned. 
The  ledger,  being  a  mere  rearrangement  of  day-book  items,  has  no 
standing  in  law,  except  as  it  is  recognized  as  a  faithful  transcript  of 
the  original  document.  It  is  not  a  recardj  but  a  summary^  for  the 
convenience  of  the  business  itself. 

A  ledger  page  looks  somewhat  as  follows : 

James  Madison 
Aug.  10  I  Mdse.  I  92  II  132I00  III  Aug.  12  |  Bills  Rec.       |  94  [|  i32[oo 

The  column  beyond  the  date  column  on  each  side  is  intended  to  show 
what  other  account  was  credited  or  debited  when  this  account  was 
debited  or  credited,  and  the  next  column  in  each  case  gives  the  page 


1 8  ACCOUNTS 

number  of  the  original  entries,  so  that  details  may  be  easily  found. 
Thus  the  ledger  serves  as  a  complete  index  for  the  day-book.  Debit 
items  are  always  placed  in  the  left  column,  and  credits  in  the  right. 
Always,  it  is  to  be  remembered,  debit  means  that  the  person  whose 
name  appears  at  the  head  of  the  space  is  the  person  responsible,  and 
not  that  the  firm  on  whose  books  the  name  occurs  is  responsible  to 
him.  Debit  means  "He  is  responsible."  All  items  occurring  under 
any  one  name  in  a  ledger  are  technically  known  as  "an  account," 
and  the  word  "  account"  will  hereafter  be  used  in  that  sense.  To  open 
an  account  is  to  introduce  a  new  name  into  the  ledger,  with  items 
attached  to  it.  If,  for  instance,  a  firm  has  been  keeping  an  account 
called  "Expense,"  and  has  been  carrying  to  it  all  items  such  as 
stationery,  lights,  fuel,  and  the  like,  and  now  it  decides  to  keep  fuel 
by  itself,  it  would  open  an  account  called  "Fuel"  in  the  ledger,  and 
would  carry  to  it  all  items  considered  to  pertain  to  fuel. 

Transferring  accounts  from  scattered  positions  in  the  day-book  to 
classified  positions  in  the  ledger  is  called  "  posting."  Our  common 
slang  expression,  "He  is  well  posted,"  is  taken  from  bookkeeping 
parlance.  We  usually  mean  by  it  that  the  latest  facts  are  classified 
in  the  man's  mind  under  their  appropriate  heads,  so  that  he  is  in  a 
position  to  summarize  the  situation.  So,  in  bookkeeping,  posting 
is  breaking  up  day-book  entries,  so  to  speak,  and  distributing  the 
parts  among  the  accounts  concerned,  so  that  the  condition  of  any 
account  may  easily  be  summarized. 

This  process  of  posting  is  easy  when  the  transaction  is  simple ;  but, 
when  many  details  are  involved,  much  care  is  necessary  to  provide 
against  error.  When  the  posting  is  done,  moreover,  one  who  is  to  see 
what  disposition  of  the  matter  was  finally  made  must  refer  to  each 
ledger  page  to  which  postings  were  carried.  Some  transactions  are 
so  complicated  that  a  memorandum  of  the  intended  disposition  of 
the  various  elements  is  a  practical  necessity  for  posting,  and  the 
preservation  of  such  a  memorandum  is  likely  to  be  a  convenience. 
From  this  necessity  and  this  convenience  sprang  up  the  old-fashioned 
journal,  which  is  simply  a  book  in  which  is  recorded  in  one  place  the 
intended  disposition,  for  posting,  of  the  elements  of  all  transactions. 
A  simple  journal  entry,  therefore,  would  look  like  this,  using  for 
illustration  the  transactions  already  given  for  the  day-book  and  the 
ledger ; 


THE  FUNDAMENTAL  BOOKS 


19 


Aug.  10 
Aug.  12 


James  Madison 
To  Mdse. 

Bills  Receivable 

To  James  Madison 


132 
132 


132 
132 


00 


00 


If,  however,  the  transaction  involved  many  details,  the  entry  would 
be  more  complicated.  Let  us  suppose,  for  illustration,  that  freight  is 
to  be  prepaid  on  the  merchandise  sent  to  James  Madison,  that  the 
amount  of  the  freight  is  to  be  added  to  his  bill,  and  that  he  is  to  pay 
extra  for  carting.  In  that  case  the  day-book  entry  would  have  in- 
cluded these  details,  and  then  the  journal  entry  would  be  as  follows : 


James  Madison 
To  Sundries 
Mdse. 
Freight 
Carting 


149 


132 
16 

I 


The  word  "sundries"  as  used  here  is  simply  to  show  that  the  equili- 
brium of  debit  and  credit,  which  must  always  be  preserved,  is  be- 
tween one  account  on  one  hand  and  a  group  of  accounts  on  the  other. 
Many  bookkeepers  do  not  use  it. 

If  the  shipment  were  made  to  two  men,  not  in  partnership,  but 
each  held  responsible  for  one  half  the  charge,  the  entry  might  read 

Sundries 

To  Sundries 

James  Madison 

James  Monroe 

Mdse.  *  132  00 

Freight  1600 

Carting  1 00 

In  making  journal  entries  bookkeepers  put  debit  items  in  left-hand 
columns  and  credit  items  in  right-hand  columns,  and  thus  posting 
may  be  done  rapidly. 

It  is  obvious  that  such  journal  entries  may  serve  not  only  as 
convenient  memoranda  of  what  debits  and  what  credits  were  made 
for  each  transaction,  but  also  as  convenient  indexes  for  day-book 
entries.  It  is  much  easier  to  find  an  entry  when  it  is  given  in  this  ab- 
breviated form  than  to  find  it  in  the  diary  form  of  the  day-book. 
This  record,  moreover,  is  made  still  more  complete  as  an  index  by 


74 

50 

74 

SO 

132 
16 

I 

20  ACCOUNTS 

means  of  the  narrow  column  just  before  the  names.  This  is  used 
as  a  check  column,  to  show  when  the  posting  has  been  made,  and  the 
check  mark  used  is  commonly  the  number  of  the  ledger  page  to 
which  the  item  has  been  posted.  It  is  important  to  note  that  such 
check  mark  should  never  be  written  until  the  posting  has  been  ac- 
tually made,  and  then  should  be  made  immediately;  for  so  many 
interruptions  occur  in  every  one's  work  that  to  check  a  posting  be- 
fore it  is  made  —  even  when  the  ledger  page  is  open  before  one  — 
is  to  run  the  risk  of  a  loss  of  the  amount  in  question  or  of  need  for  a 
long  search  for  error. 

With  the  exception  of  red-ink  memoranda,  to  be  described  in 
another  chapter,  nothing  should  ever  be  entered  in  the  ledger  except 
as  posted  from  the  journal  or  some  special  book  containing  the 
essential  features  of  the  journal. 

The  three  books  that  have  been  described  are  at  the  basis  of  all  the 
books  now  in  use:  others  are  mere  modifications  of  these,  and  an 
understanding  of  these  is  essential  for  an  understanding  of  the 
others. 


CHAPTER  FOUR 

THE  SIGNIFICANCE  OF  PARTICULAR  ACCOUNTS 

It  is  desirable,  before  discussing  further  the  form  of  books,  to 
understand  the  significance  of  the  most  important  and  most  com- 
mon accounts,  for  the  modifications  made  in  the  simpler  books 
have  been  made  with  regard  chiefly  to  the  functions  of  these  par- 
ticular accounts. 

An  account  has  already  been  defined  as  all  the  items  standing 
to  the  debit  and  the  credit  of  one  name  in  the  ledger.  Accounts  are 
of  two  sorts  —  internal  and  external.  External  accounts  are  those  i 
kept  with  persons,  partnerships,  associations,  corporations,  and: 
the  like;  they  show  the  responsibilities  of  the  business  toward 
such  persons  or  organizations,  and  the  responsibilities  of  such 
persons  or  organizations  toward  the  business.  Even  the  account  of 
a  sole  proprietor  is  an  external  account,  for  every  business  is  in 
good  accounting  considered  as  a  real  thing,  as  an  entity  apart  from 
its  proprietor.  The  business  has  relations  with  its  proprietors,  of 
course;  but  those  proprietors  are  not  the  business,  and  for  the 
purposes  of  accounting  they  are  treated  just  as  any  outsider  is 
treated  —  debited  for  property  taken  from  the  business,  and  cred- 
ited for  property  granted  to  it. 

Internal  accounts,  on  the  other  hand,  have  no  direct  relation  with 
any  one  outside  the  business,  or  even  with  the  proprietors,  but  I 
merely  represent  the  different  pieces  of  property  and  different 
forces  at  work  within  the  business  itself.  No  account  is  ever  kept, 
within  a  business,  to  represent  the  business  itself  as  a  whole,  but 
many  accounts  are  kept,  or  should  be  kept,  to  represent  the  differ- 
ent parts  or  phases  of  that  business.  Examples  of  such  accounts 
are  Merchandise  Account,  Cash  Account,  Interest  Account,  Wages 
Account. 

It  is  to  be  noted  that  no  account  should  be  opened  to  represent 
anything  which  from  the  nature  of  the  case  is  incapable  of  having, 
both  debit  and  credit  relations.  A  mere  list  can  never  be  an  account. 
For  instance,  an  account  should  not  be  called  John  Jones's  Debts;. 


22  ACCOUNTS 

for  the  title  itself  signifies  a  debit  relation  and  no  other.  How  could 
a  payment  be  recorded?  Certainly  not  among  the  debts.  If  not, 
how  could  the  payment  of  debt  be  shown  on  this  account?  The 
title  of  the  account  should  be  simply  "John  Jones."  Then  both 
debits  and  credits  may  be  entered,  and  the  balance,  if  any,  will 
show  his  exact  relation  to  the  business.  If  for  any  reason  this 
account  ought  to  be  distinguished  from  some  other  account  with 
John  Jones,  it  might  be  called  "John  Jones  Trading  Account," 
or  "John  Jones  Loan  Account,"  or  be  given  some  other  distin- 
guishing title. 

What  are  here  called  external  and  internal  accounts  are  often 
called  personal  and  impersonal  accounts;  but  the  former  desig- 
nation is  more  logical,  for  only  by  chance  is  it  true  that  external 
accounts  always  represent  persons,  and  internal  accounts  always 
represent  impersonal  things.  The  fundamental  distinction  is 
between  accounts  which  represent  the  responsibihties  of  the  busi- 
ness in  relation  with  the  outside  world  and  those  which  represent 
the  responsibilities  of  the  various  elements  of  the  business  in  rela- 
tion with  one  another. 

It  would  be  theoretically  possible  to  keep  records  of  business 
without  one  internal  account ;  but  such  records  would  fail  to  show 
sources  of  profit  or  causes  of  loss,  and  at  best  would  show  gross 
amount  of  profit  or  of  loss  only  by  means  of  a  comparison  of  pro- 
perty with  liability,  —  and  that  is  no  accounting  at  all. 

The  most  nearly  universal  internal  account  is  Cash  Account,  or 
Cash.  (The  use  of  the  word  "account"  in  ledger  titles  is  usually 
unnecessary,  and  henceforth  when  a  common  noun  is  found  spelled 
with  a  capital  letter  the  reader  will  understand  that  the  word  is 
used  as  the  title  of  a  ledger  account.)  To  Cash  go  all  items  of 
money,  checks,  and  money  orders,  but  not  usually  time  drafts  or 
negotiable  notes.  The  distinction  between  checks  and  money  orders, 
on  the  one  side,  and  notes  and  drafts,  on  the  other,  is  of  some  im- 
portance. Cash  Account  is  supposed  to  represent  funds  available 
without  bargain  or  delay.  The  law  has  protected  checks  so  much 
that  except  in  cases  of  fraud  they  are  as  good  as  money;  for  to 
issue  a  fraudulent  check  and  get  money  for  it  is  to  be  guilty  of 
obtaining  money  under  false  pretenses;  but  no  such  protection  is 
attached  to  a  note  or  a  draft.   A  note  is  a  mere  promise;   and  a 


PARTICULAR  ACCOUNTS  23 

draft,  until  accepted,  is  not  even  that.  Hence  a  check  is  cash,  and 
a  note  or  a  draft  is  otherwise  classified.  When  cash  comes  into  the 
business,  from  whatsoever  source,  the  cash  account  is  of  course 
debited,  or  charged;  for  the  cash-drawer  is  now  responsible. 
Conversely,  when  cash  is  paid,  the  cash  account  is  credited;  for 
the  cash-drawer  has  now  granted  something  for  the  needs  of  the 
business,  —  i.  e.,  has  given  up  that  for  which  it  was  responsible. 
Under  proper  conditions,  therefore.  Cash  can  never  show  a  balance 
on  the  credit  side,  for  not  more  cash  can  have  been  paid  than  has 
been  received.  Usually  a  business  house  does  not  keep  on  its  books 
an  account  with  its  bank,  but  treats  cash  on  deposit  as  if  in  its 
cash-drawer :  hence  if  its  bank  account  has  been  overdrawn,  cash 
may  show  an  excess  credit,  but  properly  each  overdraft  should  be 
entered  as  a  cash  receipt  —  for  if  honored  it  is  a  cash  loan.  The 
debit  balance  of  Cash,  of  course,  shows  the  amount  of  cash  that 
should  be  on  hand ;  for  if  all  receipts  are  debited  and  all  payments 
are  credited,  the  difference  must  represent  money  received  and  not 
yet  paid  out. 

The  account  in  which  negotiable  notes  are  recorded  is  called 
Bills  Receivable.  Drafts  which  have  been  accepted  by  those  upon 
whom  they  are  drawn  are  also  recorded  in  Bills  Receivable;  but 
drafts  which  have  not  been  accepted  are  not  recorded  at  all  on  the 
principal  books,  for  until  accepted  they  have  no  value  other  than 
that  of  any  written  request.  It  should  be  noted  that  Bills  Receivable 
has  a  restricted  significance,  and  does  not  at  all  include  ordinary 
so-called  "open  accounts,"  or  "book  accounts,"  i.  e.,  sums  owed 
to  a  business  by  customers  to  whom  it  has  sold  goods  on  trust. 
The  term  "Bills  Receivable"  is  used  only  of  promises  to  pay 
written  in  the  form  of  promissory  notes  or  of  accepted  drafts. 
It  is  to  be  noted,  too,  that,  when  a  purchaser  gives  a  note  for  goods 
bought,  the  charge  for  the  goods  must  no  longer  stand  against 
him  on  the  books:  he  has  paid  for  the  goods  by  surrendering  in 
exchange  another  form  of  property — a  negotiable  note, — and  if 
he  fails  to  pay  the  note  suit  is  brought  not  for  payment  on  the 
goods,  but  for  payment  on  the  note.  Bills  Receivable,  therefore, 
has  a  definite  technical  significance.  This  account  is  debited,  or 
charged,  of  course,  when  notes  are  received :  that  is,  a  note,  being 
property,  must  be  cared  for  and  responsibility  for  it  must  be  re- 


24  ACCOUNTS 

corded;  and  that  responsibility  being  taken  by  a  file  in  the  safe, 
the  account  which  represents  that  file,  Bills  Receivable,  is  debited. 
The  same  thing  may  be  put  in  another  way.  Originally  the  man 
who  bought  the  goods  was  held  responsible  for  payment,  and  he 
got  rid  of  that  particular  responsibiUty  by  signing  a  note  which 
served  as  a  simpler  form  of  claim  upon  him.  As  just  noted,  suit 
against  him,  if  made  at  all,  must  now  be  made  upon  the  note ;  and 
as  the  note  has  now  become  responsible  for  the  ultimate  payment 
on  those  goods.  Bills  Receivable  should  be  debited.  Conversely, 
when  a  note  held  by  the  business  in  its  favor  is  paid.  Bills  Receiv- 
able is  credited,  for  it  has  then  brought  money  into  the  business, 
or,  if  you  prefer  to  put  it  that  way,  has  performed  its  responsibiUty. 
It  is  to  be  noted  that  Bills  Receivable  represents  the  jace  value  of 
notes  and  not  their  cost  or  real  value.  It  cannot,  therefore,  show  a 
credit  balance ;  for  not  more  can  have  been  credited  on  such  notes 
than  the  face  of  the  notes  called  for.  If  any  excess  has  been  col- 
lected, the  excess  was  not  on  account  of  Bills  Receivable  but  on 
account  of  interest,  and  Interest  should  be  credited.  The  debit 
balance  of  Bills  Receivable,  of  course,  shows  the  face  value  of 
notes  that  should  be  on  hand. 

A  similar  account  is  Bills  Payable.  This  represents  not  bills  the 
business  owes  on  "open  account,"  but  negotiable  notes  that  it  has 
signed,  or  drafts  that  it  has  accepted,  promising  to  pay  in  the  future. 
The  treatment  of  Bills  Payable  is  similar,  though  of  course  reversed, 
to  that  of  Bills  Receivable.  When  the  business  issues  a  note,  either 
in  payment  for  goods  or  to  secure  a  loan,  Bills  Payable  is  credited; 
for  Bills  Payable  has  stepped  in  and  conferred  a  benefit  upon  the 
business  —  has  paid  a  bill  for  it  or  has  borrowed  money  for  it. 
Conversely,  when  a  note  issued  by  the  business  is  paid  by  it,  Bills 
Payable  is  debited ;  for  Bills  Payable  is  responsible  for  the  outgo 
—  as  the  weather  is  responsible  for  a  delay.  The  Bills  Payable 
balance  must  always  be  on  the  credit  side,  for  not  more  notes  can 
have  been  paid  than  ever  were  issued.  If  any  excess  has  been  paid, 
the  excess  was  on  account  of  interest  and  should  be  debited  to 
Interest.  The  credit  balance  to  Bills  Payable,  of  course,  shows 
the  jace  value  of  notes  outstanding  against  the  business.^ 

'  Inexperienced  persons  usually  have  more  trouble  deciding  between  debit  and 
credit  for  entries  to  Bills  Payable  than  to  any  other  account.  Usually,  if  Bills  Payable 


PARTICULAR  ACCOUNTS  2$ 

An  account  should  always  be  kept  with  interest  and  discount. 
Interest  is  a  sum  paid  by  a  borrower  in  addition  to  the  principal 
sum  which  he  in  his  note  or  other  obHgation  has  promised  to  pay ; 
discount,  on  the  other  hand,  is  a  sum  taken  out  of  the  loan,  in 
advance,  by  the  lender,  but  not  reducing  the  principal  sum  called 
for  by  the  note  at  the  maturity  of  the  loan.  If  a  man  writes  a  note 
for  a  thousand  dollars  payable  in  a  year  with  interest  at  six  per  cent., 
and  can  borrow  a  thousand  dollars  on  it,  he  pays  at  the  end  of  the 
year  a  thousand  sixty  dollars,  of  which  sixty  dollars  is  interest.  If, 
on  the  other  hand,  he  writes  a  similar  note  not  bearing  interest, 
he  can  borrow  at  a  bank  nine  hundred  forty  dollars,  and  at  the 
expiration  of  the  year  he  must  pay  one  thousand  dollars.  In  this 
last  case  the  sixty  dollars  taken  out  of  the  loan  in  advance  is  called 
discount,  but  though  at  a  slightly  higher  rate  than  interest  (sixty 
dollars  for  nine  hundred  forty,  instead  of  sixty  dollars  for  a  thou- 
sand), it  is  of  the  same  nature,  and  the  two  do  not  need  to  be  dis- 
tinguished in  accounting.  The  account  that  represents  them  is 
usually  called  simply  " Interest."^  Interest  is  of  course  debited  when 
interest  is  paid  out,  or  discount  lost,  for  then  that  force  which  in 
business  we  call  interest  is  responsible  for  the  loss ;  and,  conversely, 
when  interest  is  paid  into  the  business,  or  discount  is  received, 
Interest  is  credited,  for  then  the  force  which  we  call  interest  has 
conferred  a  benefit  on  the  business.    A  debit  balance  of  Interest 

is  considered  as  if  it  represented  a  person  and  then  all  entries  are  made  on  that  as- 
sumption, the  difficulties  will  be  removed.  If,  when  you  wished  to  pay  a  bill  and  had 
not  the  money,  a  friend  paid  it  for  you,  you  would  credit  him ;  so,  too,  if  a  friend 
borrowed  money  for  you  and  turned  it  over  to  you,  you  would  credit  him.  Then  when 
Bills  Payable  satisfies  a  creditor  and  enables  you  to  pxjstpone  payment,  or  enables 
you  to  borrow  money,  credit  Bills  Payable.  When  you  pay  the  friend,  you  debit  him: 
so  when  you  pay  the  note,  debit  Bills  Payable. 

^  There  is  a  theoretical  true  discount  which  is  at  no  higher  rate  than  interest, 
making  the  loan  nine  hundred  forty-three  dollars  and  thirty-nine  cents,  but  it  is 
practically  always  supplanted  by  bank  discount,  which  includes  profit  for  the  bank 
not  only  on  what  it  loans,  but  also  on  the  discount  taken  out. 

Still  a  third  sort  of  discount  is  common,  but  this  last  sort  is  not  usually  included 
with  interest.  It  consists  of  a  reduction  in  price  of  goods  when  payment  for  them  is 
made  promptly,  as  when  two  per  cent,  is  subtracted  for  immediate  payment,  as  in 
some  lines  of  business,  or  five  per  cent,  for  payment  in  thirty  days,  as  in  others.  Such 
discounts  are  usually  called  merchandise  discounts,  and  are  kept  distinct  or  in- 
cluded with  merchandise ;  and  we  shall  have  occasion  to  discuss  them  later. 


26  ACCOUNTS 

means  that  the  interest  paid  on  money  borrowed  amounts  to  more 
than  the  interest  earned  on  money  lent;  and  vice  versa. 

Until  one  has  become  accustomed  to  the  idea  of  interest  affect- 
ing values,  one  is  puzzled  by  the  necessary  entries  to  Interest.  The 
first  thing  to  realize  is  that  a  claim  enforceable  in  the  future  is 
worth  less  than  a  claim  enforceable  now;  the  second  thing  to  realize 
is  that  no  interest  is  payable  on  a  note  or  other  obHgation  unless 
interest  is  mentioned.  Hence  a  note  for  $1000  payable  in  thirty 
days  is  worth  (unless  interest  is  mentioned)  less  than  $1000.  A 
note  for  $1000  payable  in  thirty  days  with  interest  is  worth  $1000 
to-day.  A  note  payable  thirty  days  hence  but  dated  thirty  days 
since  and  bearing  interest  is  worth  more  than  its  face,  for  the  owner 
has  already  a  claim  to  interest  in  excess  of  its  face  (and  the  interest 
to  accumulate  in  the  future  will  compensate  for  the  postponement 
of  payment).  A  note  payable  in  the  future  without  interest,  how- 
ever, even  though  dated  in  the  past  is  worth  no  more  than  one  dated 
to-day  and  payable  at  the  same  future  date;  for  no  accumulation 
has  occurred  on  it.  Finally,  though  a  note  may  be  worth  less  than 
its  face  value,  it  may  be  for  certain  purposes  of  exchange  accept- 
able at  face.  If,  for  example,  a  merchant  buys  goods  with  the  under- 
standing that  he  shall  pay  in  sixty  days,  his  note  payable  in  sixty 
days  (without  interest),  though  not  worth  its  face  to-day,  is  accept- 
able payment  and  must  be  credited  to  him  at  face ;  for  the  mer- 
chandise was  not  worth  selling  price,  or  billed  value,  if  sixty  days 
was  allowed  for  payment;  and  the  note  is  therefore  as  good  as  the 
merchandise.  Yet  the  merchant  taking  the  note  in  payment  of  the 
bill  cannot  get  face  value  for  it  before  maturity  if  he  attempts  to 
pass  it  along. 

To  illustrate  the  application  of  these  principles,  suppose  we  bor- 
row money  on  a  note  dated  to-day  and  payable  in  two  months  for 
$1000.  The  note  is  worth  $990  (assuming  6%  as  the  rate  of  dis- 
count) and  that  is  all  we  can  get  for  it.  Interest  must  be  debited 
for  the  ten  dollars  difference  between  the  credit  to  Bills  Payable 
and  the  debit  to  Cash.  When  we  pay  the  note,  however,  we  need 
no  entry  to  Interest,  for  we  pay  a  note  for  $1000  with  $1000  of  cash. 
If,  on  the  other  hand,  we  had  made  the  note  payable  with  interest, 
it  would  have  been  worth  face  value  and  we  should  have  got  licx^o 
for  it.   Our  original  entry,  therefore,  would  have  required  no  men- 


PARTICULAR  ACCOUNTS  27 

tion  of  interest,  but  would  have  indicated  a  mere  exchange  of  val- 
ues, $1000  in  a  note  for  $1000  in  cash.  At  the  time  of  payment, 
however,  $1010  in  cash  would  go  out  for  a  note  of  $1000,  and  the 
entry  would  need  to  explain  the  difference  —  as  a  debit  to  Interest. 
We  may  say,  then,  that  the  entry  is  made  at  the  time  the  transac- 
tion culminates,  —  that  is,  when  the  allowance  for  interest  has 
resulted  in  a  transaction,  even  though  the  interest  itself  is  not  yet 
paid.  In  the  case  of  the  non-interest-bearing  note  above,  the  in- 
terest was  not  actually  paid  until  maturity;  but  the  entry  was 
made  at  the  time  of  discount,  for  the  culmination  of  the  transac- 
tion, so  far  as  interest  is  concerned,  was  when  the  borrower  gave  a 
note  for  $1000  though  he  had  borrowed  but  $990  —  the  interest 
really  happened  at  the  giving  of  the  note,  in  its  incorporation  in 
the  face  of  the  note.  If,  to  take  another  sort  of  case,  a  man  owes  us 
money  payable  in  two  months  but  gives  us  a  note  payable  in  one 
month,  we  should  allow  him  for  the  early  payment.  We  may  ac- 
cept the  note,  then,  as  applied  to  the  debt,  at  more  than  its  face 
value,  though  it  is  worth  actually  less  than  face  value.  The  differ- 
ence is  an  allowance  for  interest;  though,  since  the  note  bears  no 
interest,  none  will  ever  actually  be  paid.  Our  entry  will  debit  In- 
terest, however,  at  the  time  of  the  transaction,  for  at  that  time  the 
interest  will  have  actually  happened  in  the  allowance  made  in  set- 
tling his  bill.  To  be  specific,  if  his  bill  is  for  $1000  payable  in  two 
months  and  he  gives  us  a  note  for  $995  payable  in  one  month,  we 
should  (if  we  agree  to  accept  early  payment  at  a  fair  adjustment) 
cancel  his  debt  to  us  by  debiting  Bills  Receivable  $995  and  Inter- 
est $5,  and  crediting  him  $1000. 

The  working  of  the  principle  may  be  summarized  in  tabular 
form.  Let  us  suppose  the  following  transactions  take  place  on  July 
I  and  pertain  to  notes  with  a  face  of  $1000.  [When  no  interest  rate 
is  given  in  the  table  the  note  does  not  bear  interest.] 


Date  of 

Time  to 

Interest 

Value  of 

Transac- 

Interest 

a/c 

note 

run 

rate 

note 

tion 

Entry 

Amount 

July  I 

2  mos 

$  990 

Issue 

Dr. 

10 

July  I 

2  mos 

6% 

1000 

Issue 

None 

— 

June  I 

2  mos 

6% 

1005 

Sale 

Cr. 

5 

June  I 

I  mo 

ICXX) 

Purchase 

None 

— 

June  I 

I  mo 

6% 

1005 

Purchase 

Dr. 

5 

June  I 

I  mo 

1000 

Collection 

None 

— 

May  I 

2  mos 

6% 

lOIO 

Collection 

Cr. 

10 

28  ACCOUNTS 

Banks  commonly  in  the  second  case  above  discount  the  $ioio 
ultimately  to  be  paid  and  give  but  $999.90;  but  properly  they 
should  give  $1000. 

Another  almost  universal  account  is  Expense.  To  this  may  be 
charged  all  expenditures  incurred  in  conducting  the  business,  such 
as  for  postage,  stationery,  telegrams,  office-rent,  clerk-hire,  insurance. 
A  debit  to  this  account  shows,  of  course,  that  the  force  in  business 
which  requires  such  expenditures  is  responsible  for  that  outgo. 
Credit  entries  to  Expense  are  rare,  for  only  when  an  outgo  of  this 
sort,  which  was  expected  to  be  permanent,  happens  to  be  refunded 
can  the  account  grant  anything  to  the  business.  If  you  pay  fifty 
dollars  a  year  to  a  railroad  for  the  maintenance  of  a  private  spur- 
track  to  your  warehouse,  and  a  neighbor  who  is  allowed  occasionally 
to  use  that  track  gives  you  in  compensation  ten  dollars  a  year,  that 
ten  dollars  should  be  credited  to  Expense.  This  expense  account 
is  perhaps  the  most  elastic  account  in  general  bookkeeping.  It  may 
theoretically  include  so  many  things  that  in  actual  practice  it  is 
possible  to  find  perhaps  a  hundred  business  houses  no  two  of  which 
put  quite  the  same  things  into  their  expense  accounts.  A  business 
house  having  many  or  heavy  insurance  charges  is  likely  to  wish  to 
know  just  what  it  pays  for  insurance  each  year ;  and  such  a  house 
will  keep  a  separate  account  for  insurance,  omitting  insurance  from 
Expense.  Similarly,  special  accounts  may  be  kept  with  postage, 
stationery,  telegrams,  rent,  and  wages.  Hence  Expense  may  shrink 
to  insignificance,  or  disappear  entirely;  but  in  such  cases  some 
other  accounts  are  sure  to  perform  its  function,  and  these  special 
accounts  should  be  treated  exactly  as  Expense  itself  would  be 
treated. 

In  all  mercantile  houses,  and  in  most  manufacturing  establish- 
ments, an  account  is  kept  for  merchandise.  Merchandise  Account 
is  debited  when  goods  are  bought,  of  course,  for  the  account,  repre- 
senting the  warehouse,  is  responsible  for  the  care  of  the  goods; 
and  Merchandise  is  credited  when  goods  are  shipped,  for  then  the 
warehouse  has  surrendered  its  responsibility.  It  is  now  to  be  noted 
that  Merchandise  is  debited  for  goods  at  the  buying  price  and  is 
credited  for  them  at  the  seUing  price,  the  difference  indicating  gross 
profit.  Merchandise  Account,  then,  does  not,  Hke  Cash  or  Bills 
Receivable,  represent  property  merely;  nor  does  it,  Hke  Interest 
and  Expense^  represent  a  mere  force :  it  is  both  a  property  account 


PARTICULAR  ACCOUNTS  29 

and  a  force  account.  This  compels  us  to  consider  more  deeply  than 
we  have  yet  done  the  difference  between  property  accounts  and  force 
accounts,  and  the  relation  between  them.  This  can  well  be  done 
by  using  for  illustration  the  accounts  that  we  are  already  familiar 
with. 

Cash  is  a  pure  property  or  resource  account.  No  profit  or  loss 
can  be  figured  from  it.  Though  the  excess  of  cash  debits  over  cash 
credits  represents  the  excess  of  cash  receipts  over  cash  disburse- 
ments, it  does  not  show  whether  that  excess  was  received  as  pro- 
prietor's investment,  as  a  loan,  or  as  the  profits  of  the  business. 
Those  things  must  be  shown  by  other  accounts  —  the  accounts  that 
were  credited  when  Cash  was  debited.  The  same  thing  is  true  of 
Bills  Receivable.  It  is  a  pure  property  account.  No  profit  can  be 
figured  from  it ;  for  if  any  profit  has  been  made  in  connection  with 
the  notes,  that  profit  is  of  the  nature  of  interest  or  of  payment  for 
risk  in  the  acceptance  of  doubtful  paper,  and  should  be  recorded 
under  other  heads.  The  same  sort  of  thing  is  true  of  Bills  Payable, 
except  that  it  represents  negative  property,  i.  e.,  debts.  Interest, 
on  the  other  hand,  does  not  in  any  sense  represent  property:  it 
merely  records  explanations  of  changes  in  property  accounts. 
Every  change  in  a  property  account  must  be  explained,  and  if  that 
explanation  is  not  a  mere  transfer  or  exchange  of  one  kind  of  pro- 
perty for  another,  some  business  force  must  be  called  in  for  explana- 
tion :  the  force  that  we  call  interest  often  furnishes  an  explanation, 
and  this  is  recorded  in  the  account  called  Interest.  Such  explana- 
tion accounts  or  force  accounts  are  commonly  called  "nominal  ac- 
counts," to  distinguish  them  from  "real,"  or  property  accounts.  A 
nominal  account,  therefore,  it  must  be  clearly  understood,  never 
represents  a  tangible  thing:  the  tangible  thing  is  in  a  property  ac- 
count, such  as  cash,  and  the  explanation  of  the  change  in  property 
is  to  be  found  in  a  nominal  account,  such  as  Interest.  The  Expense 
Account  and  accounts  akin  to  it  are  similar  to  Interest,  in  that  they 
are  purely  nominal  and  record  the  explanations  of  changes  in  real 
accounts.  Perhaps  this  can  be  made  clearer  by  a  problem.  Suppose 
the  "real"  accounts  of  a  firm  show  an  excess  of  debits  over  credits 
amounting  to  $20,000,  —  i.  6.,  its  property  is  $20,000  in  excess  of  its 
liabilities.  Do  we  know  anything  then  about  the  state  of  its  "nomi- 
nal" accounts,  i.  e.,  its  force  or  explanation  accounts?   If  the  pro- 


30  ACCOUNTS 

perty  exceeds  the  liabilities,  whence  came  that  property  ?  It  cannot 
have  been  investment  by  the  proprietor,  for  any  investment  that 
he  has  made  must  have  been  credited  to  him,  and  hence  must  appear 
among  the  habilities  which  the  property  exceeds.  Such  excess  cannot 
have  come  from  loans,  for  such  loans  must  also  be  included  among 
the  Habilities.  The  excess,  then,  can  be  nothing  but  profit  or  earn- 
ings ;  and  as  all  profits  have  been  registered  as  credits  in  some  nom- 
inal account  —  i.  e.,  force  or  explanation  account,  —  this  excess 
must  be  so  registered.  The  excess  credits  of  nominal  accounts 
must  equal  the  excess  debits  of  property  accounts.  Conversely,  if 
the  nominal  accounts  show  a  credit  balance,  i.  e.,  a  profit,  we  know 
that  the  property  accounts  must  show  a  debit  balance,  i.  e.,  an 
excess  of  property ;  for  if  the  profit  shown  by  the  nominal  accounts 
has  not  been  made  in  property — cash,  goods,  or  claims,  —  it  has 
not  been  made  at  all.  Although  the  property  accounts  include  the 
profit  that  has  been  made,  they  do  not  register  the  amount  of  profit, 
but  mingle  it  with  investment  and  loans.  Only  nominal  accounts 
register  the  amount  of  profit. 

Merchandise  Account,  we  have  seen,  is  both  real  and  nominal. 
So  far  as  it  represents  property,  that  is,  merchandise  on  hand,  and 
it  always  does  that  when  any  goods  are  on  hand,  it  is  real;  and  so 
far  as  it  represents  profits  on  goods  sold,  and  it  always  does  that 
when  any  have  been  profitably  sold  since  the  last  closing  of  the 
books,  it  is  nominal.  How  much  of  the  balance  of  Merchandise  is 
one  or  the  other  cannot  be  told  off-hand,  and  hence  an  inventory  of 
stock  on  hand  is  necessary  for  the  interpretation  of  this  account. 
With  such  an  inventory,  conclusions  are  easily  drawn.  The  method 
of  interpreting  a  combination  account  Hke  Merchandise  may  be 
shown  by  a  simple  illustration.  Suppose  Merchandise  shows  a 
debit  total  on  the  ledger  of  $50,000,  and  a  credit  total  of  $60,000. 
In  that  case  it  is  obvious  that  merchandise  has  cost  $50,000,  and 
that  merchandise  has  been  sold  for  $60,000 ;  but  this  does  not  mean 
necessarily  that  a  gross  profit  of  only  $10,000  has  been  earned,  for 
perhaps  some  of  the  original  $50,000  worth  is  still  on  hand  and 
therefore  $60,000  has  come  in  from  the  sale  of  only  a  part  of  the 
stock.  In  that  case,  if  the  inventory  shows  a  stock  on  hand  to  the 
amount  of  $10,000,  clearly  $40,000  worth  of  goods  has  been  sold  for 
$60,000  and  the  profit  has  been  $20,000.    Of  the  totals  appearing 


PARTICULAR  ACCOUNTS  3 1 

under  Merchandise  in  the  ledger,  therefore,  $10,000  of  the  debit 
was  property,  and  $20,000  of  the  credit  was  profit.  Only,  then,  by 
reading  Merchandise  in  connection  with  an  inventory  can  one  find 
the  significance  of  that  account.^ 

An  account  of  great  importance,  though  usually  having  but  few 
entries,  is  Loss  and  Gain,  or  Profit  and  Loss.  It  is,  of  course,  as 
already  hinted,  an  explanation  account,  measuring  increase  or  de- 
crease in  the  value  of  property  held.  No  system  of  bookkeeping  is 
likely  to  provide  accounts  for  all  sources  of  income  or  causes  of  loss. 
In  fact  it  is  hardly  worth  while  to  distinguish  trivial  and  exceptional 
causes  of  loss  or  gain.  They  may  well  be  lumped.  Usually  during 
the  course  of  the  year  entries  are  made  to  Loss  and  Gain  only  for 
exceptional  trivial  things,  though  if  the  attempt  to  distinguish  be- 
tween different  sources  of  income  or  causes  of  loss  is  not  carried 
very  far,  such  things  as  losses  by  bankruptcy  are  likely  to  go  to  this 
account.  At  the  close  of  a  year,  however,  it  is  customary  to  transfer 
to  this  account  from  the  other  ledger  accounts  all  losses  or  gains  of 
whatever  sort  and  of  whatever  magnitude.  Thus  a  summary  of  the 
year's  business  is  available  in  simple  form.  Any  balance  undisposed 
of  at  the  final  settlement  may  continue  over  to  the  new  year  if  the 
managers  so  desire. 

The  number  of  accounts  that  may  be  kept  in  a  ledger  is  infinite. 
An  account  should  be  kept  with  every  person,  kind  of  property,  and 
force,  which  if  kept  distinct  could  help  to  an  understanding  of  the 
amount  of  profit,  loss,  or  valuation,  the  cost  of  production  or  of  ser- 
vice, the  resources  and  liabilities,  or  the  causes  and  sources  of  loss 
or  gain. 

A  few  illustrations  of  the  use  of  these  accounts  as  they  would 
appear  in  the  simplest  possible  form  may  now  be  given.  In  order  to 
give  in  summary  form  a  review  of  general  principles  up  to  this 
point,  the  transactions  will  be  followed  through  from  the  day-book 
to  the  ledger. 

*  In  some  lines  of  business  it  is  possible  to  distinguish  in  the  record  between  cost 
price  and  selling  price  for  all  sales,  and  then  two  distinct  accounts  with  merchandise 
may  be  kept,  thus  avoiding  the  necessity  for  reference  to  an  inventory.  Yet  even  in 
those  lines  of  business  the  use  of  an  inventory  in  connection  with  some  accounts  is 
unavoidable.  So  the  principle  her^  explained  is  essential  even  when  it  is  not  applied  in 
this  particular  account. 


32 


ACCOUNTS 


DAY-BOOK 


August  I 

Borrowed  of  William  Patterson,  on  my  note,  dated  to-day, 

payable  in  four  months,  with  interest  at  6% 

[It  is  recommended  that  the  reader  who  wishes  to  fol- 

1000 

00 

low  these  pass  at  once  from  this  entry  to  the  corre- 

sponding journal  entry,  on  page  33,  and  thence  to 
the  ledger  entries,  before  going  on  to  the  second  day- 
book entry  here;  and  so  on.] 

2 
John  Straw  paid  his  bill  of  July  2,  payable  to-day,  by  his 
note  for  $500,  dated  to-day  and  payable  in  60  ds.   Discount 

$5-oo 

495 

GO 

Sold  Oliver  Twist  12  M.  pine  boards  @  20 

240 

GO 

3 
Sold  Dombey  &  Son  standing  timber  in  lot  5(^75,  for  cash 

5 
Took  up  note  of  Aug  i,  payable  to  William  Patterson 

2000 

CO 

1000 

00 

Interest 

67 

Received  from  Nicholas  Nickleby,  in  payment  of  his  bill 
of  July  5,  due  to-day,  a  note  of  Adam  Bede,  dated  August  i, 
on  60  ds.,  for  $500,                                                                    495-33 
and  Cash                                                                                       75 -40 

570 

73 

Felix  Holt  credited  for  last  month's  salary 

6 
Discounted  at  the  Second  National  Bank  J.  Straw's  note 

100 

00 

of  Aug.  2.    Discount  $4.67  ^ 

495 

33 

7 
Paid  F.  Holt  his  salary  to  8/5 

100 

00 

The  journal  entries  for  these  transactions  follow : 

1  The  journalization  and  posting  of  this  transaction  are  shown  beyond  as  commonly 
made,  but  the  method  is  not  recommended  for  accounting  purposes.  The  plan  used 
here  is  the  simplest,  and  is  used  here  because  it  well  illustrates  the  principle  of  debit 
and  credit.  The  improved  accounting  method,  too  technical  for  discussion  in  this  ele- 
mentary  chapter,  is  explained  in  Chapter  DC. 


PARTICULAR  ACCOUNTS 


JOURNAL 


33 

[page  60 1 


9 

15 


13 

43 
20 


39 
II 

9 
II 


9 
15 
20 


13 

9 

37 

20 


August  I 
Cash 
To  Bills  Payable 

[Note  that  William  Patterson  does  not 
need  to  appear  upon  the  books,  for  the 
note  serves  as  suflicient  evidence  of  his 
claim.    Since  the  note  bears  interest, 
no  discount  is  taken.] 
2 
Bills  Receivable 
To  Sundries 
J.  Straw 
Interest 

[Note  that  this  entry  debits  Bills  Re- 
ceivable for  the  face  of  the  note,  credits 
J.  Straw  for  what  the  note  is  worth  to- 
day, and  credits  Interest  with  interest 
earned  —  and  that  interest  is  now  re- 
corded as  earned  because  the  safe  al- 
ready holds  evidence  of  it  through 
J.  Straw's  note  promising  to  pay  that 
interest  (which  is  the  difference  be- 
tween $495.00  and  $500.00)  at  the  end 
of  the  time.) 

Oliver  Twist 
To  Mdse. 

3 
Cash 
To  Mdse.  (or,  perhaps.  Standing  Timber) 

5 
Sundries 

To  Cash 
Bills  Payable 
Interest 

Sundries 

To  Sundries 
Bills  Receivable 
Cash 
Nicholas  Nickleby 
Interest 

[Sufficient  explanation  of  this  is  found 
in  connection  with  the  entry  for  Aug.  2.] 


1000 


500 ' 


495 
5 


240 


2000 


1000 


500 
75 


00 


00 


240 


00 


00 


67 


57073 
467 


34 


ACCOUNTS 


[page  6i] 


JOURNAL  (continued) 


21 

44 


13 
9 

20 


44 
9 


Expense 
To  Felix  Holt 


August  5 


Sundries 
To  Bills  Receivable 

Cash 

Interest 

[Note  here  that  interest  is  lost,  and 
hence  Interest  Account  is  debited  or 
held  responsible  just  as  in  the  first 
entry  for  Aug.  2  it  was  credited.  The 
difference  between  the  two  amounts, 
an  excess  on  the  credit  side,  is  thirty- 
three  cents,  showing  that  the  business 
by  holding  that  note  for  four  days  — 
that  is,  by  what  is  practically  lending 
the  money  for  four  days  —  earned  that 
amount  in  interest.  1 

7 
Felix  Holt 
To  Cash 


495 
4 


IOC 


500 


100 


00 


GO 


00 


These  items  when  posted  to  the  ledger  would  look  as  follows; 


LEDGER 


Aug.  5  I  Cash 


I  60 


Bills  Payable 

icx5o|oo  III  Aug.  I 


Cash 


[page  15] 

60  II  loooloo 


Aug.  1 
"  3 
"  5 
"     6 


Cash 

Bills  Pay. 

60 

1000 

00 

Aug.  5 

Mdse. 

60 

2000 

00 

Aug.  7 

N.  Nickleby 

60 

75 

40 

Bills  Rec. 

61 

495 

33 

1 

Sundries 
F.  Holt 


60 
61 


[page  9] 


1000 
100 


Aug.  2 
"   5 


Sundries 


60 
60 


Bills  Receivable 


50000 
500I00 


Aug.  6  I  Sundries 


[page  13] 
61  II    5oo|oo 


PARTICULAR  ACCOUNTS 


35 


LEDGER  (continued) 


Aug.  7  I  Cash 


I  6i 


F.  Holt 

loojoo  II  Aug.  5  I  Expense 

Expense 


J.  Straw 

[page  43I 

I 

1        1 

1      III  Aug..  1 
Interest 

Bills  Rec. 

1  60  \\     495!oo 
[page  20] 

Aug.  5 
"     6 

Cash 
Bills  Rec. 

6o 
6i 

67       Aug.  2 
467         "     5 

Bills  Rec. 

60 
60 

500 
467 

Oliver  Twist 

[page  39] 

Aug.  2  1  Mdse. 

1  6o  1 

1    240I00III 
Mdse. 

1        II          1 
[page  11] 

Aug.  2 
"      3 

0.  Twist 
Cash 

60        240 
60       2000  CX) 

J 

sIlCHOLAS  NiCKLEBY 

[page  37] 

1 

1        1 

1     1  1 

1  Aug.  5 

Sundries 

1  60 

1     570I73 

61 


[page  44I 


100  00 


[page  21] 

Aug.  5    F.  Holt  1        I  61  II     ioo|oo  II!  I  I        II  I 

[This  ledger  shows  only  the  postings  of  the  items  given.  Of  course  pre- 
vious items  must  be  taken  for  granted,  for  otherwise  J.  Straw  and  N. 
Nickleby  could  have  owed  nothing  to  the  business.] 

Those  w^ho  are  interested  to  see  the  use  of  a  few  accounts  which 
are  less  common,  under  circumstances  of  natural  but  infrequent 
occurrence,  will  find  some  illustrations  of  journalization  for  them  in 
Appendix  B. 

'  1  Many  bookkeepers  do  not  in  the  ledger  fill  in  the  name  of  the  other  account  con- 
cerned in  the  transaction  —  e.g.,  the  account  credited  when  the  account  to  which  post- 
ing is  made  was  debited.  Nevertheless,  this  is  often  worth  while;  for,  in  the  first  place, 
it  gives  siunmary  information  and  usually  obviates  the  necessity  of  looking  back  to  the 
original  entry  in  cases  where  information  is  sought;  and,  in  the  second  place,  it  requires 
very  little  labor,  for  in  most  accounts  all  the  debits  have  a  similar  origin  and  all  the 
credits  are  similar,  and  hence  after  the  first  entry  on  each  side  ditto  marks  serve  thn 
purpose. 


CHAPTER  FIVE 

THE  TRIAL  BALANCE,  THE  STATEMENT,  AND  THE  BALANCE 

SHEET 

Before  we  pass  on  to  a  study  of  the  various  typical  methods  of  ab- 
breviating the  labor  of  keeping  records,  it  may  be  well  to  carry  these 
simple  forms  to  their  conclusions  in  a  trial  balance,  a  six-column 
statement,  and  a  balance  sheet;  for  these  last  devices  remain  un- 
changed in  spite  of  all  the  changes  of  method  in  making  original 
entries,  and  an  understanding  of  them  is  an  assistance  in  under- 
standing the  methods  of  abbreviation. 

It  has  been  noted  all  along  that  debits  must  equal  credits.  When 
an  entry  has  many  parts,  it  is  not  surprising  if  some  part  be  inad- 
vertently lost.  A  simple  test  is  to  add  together  all  the  debits  and  then 
all  the  credits  of  that  entry,  and  see  whether  the  requirement  of 
correspondence  is  met.  The  second  journal  entry  for  August  5,  on 
page  31,  is  an  illustration  of  a  case  in  which  the  bookkeeper  is  likely 
to  find  satisfaction  in  making  a  test.  It  may  be  worth  while  simply 
to  add  the  total  of  each  journal  column,  one  debit  and  one  credit, 
page  by  page,  on  the  presumption  that  if  the  comparison  is  correct 
for  a  page  as  a  whole  it  is  correct  for  each  entry.  Yet  even  if  the 
journal  correspondence  holds  true,  that  fact  is  no  evidence  that 
the  correspondence  will  hold  true  on  the  ledger,  for  errors  in  post- 
ing are  not  always  easy  to  avoid.  A  test  of  the  ledger  may  also  be 
made,  however,  and  usually  is  made  under  the  name  of  the  "  trial  bal- 
ance." 

A  trial  balance  is  nothing  but  a  list  of  the  open  accounts  in  the 
ledger  with  an  extension  opposite  the  name  of  each  account  showing 
the  amount  of  debit  or  credit  balance  (or  debit  and  credit  total,  if 
the  bookkeeper  finds  it  easier  to  write  both  totals  than  to  figure  the 
difference  between  them).  For  the  ledger  beginning  on  page  34, 
the  trial  balance  would  look  as  follows,  —  debits  being  here,  as 
everywhere,  in  the  left  column  and  credits  in  the  right : 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET   37 


9 

Cash 

13 

Bills  Receivable 

43 

J.  Straw 

20 

Interest 

39 

0.  Twist 

II 

Mdse. 

37 

N.  Nickleby 

21 

Expense 

2470 

06 

500 

00 

495 
4 

240 

00 

2240 
570 

100 

00 
06 

33^0 

33^0 

The  principle  of  the  trial  balance  is  obvious  enough.  Clearly 
the  total  of  all  credits  posted  to  the  ledger  must  equal  the  total  of 
all  debits  posted  to  the  ledger.  A  balance  is  simply  the  excess  of 
one  side  over  the  other,  —  that  is  to  say,  the  two  sides  are  equal 
except  for  the  balance.  When,  then,  in  taking  a  trial  balance  the 
bookkeeper  omits  all  accounts  which  have  no  balance,  and  takes 
from  other  accounts  only  the  excess  of  one  side  over  the  other,  he 
is  simply  omitting  from  his  test  of  the  ledger  those  debits  and 
credits  which  have  already  shown  themselves  to  be  equal  and  there- 
fore beyond  the  need  of  test.  If  the  parts  tested  show  themselves 
equal,  and  the  parts  not  tested  are  already  known  to  be  equal, 
obviously  the  totals  must  be  equal. 

In  the  ledger  before  us,  since  the  accounts  of  Bills  Payable  and 
Felix  Holt  show  no  balances,  those  accounts  do  not  appear.  No 
ledger  could  in  practice  look  quite  like  this  one,  for,  as  has  been 
already  suggested,  previous  transactions  must  have  taken  place,  — 
else  J.  Straw  and  N.  Nickleby  could  not  owe  the  business,  and 
merchandise  could  not  be  sold  before  any  had  been  bought;  but 
we  may  be  sure  that  the  previous  transactions  must  also  have  had 
a  correspondence  of  debit  and  credit,  and  these  equal  balances 
added  to  old  equal  balances  must  produce  totals  that  are  equal. 
So  the  trial  balance  is  correct  for  our  purpose. 

It  is  easy  either  to  overstate  or  to  understate  the  value  of  a  trial 
balance.  The  trial  balance  proves  nothing ;  and  yet  by  the  law  of 
chance  it  is  very  good  evidence  that  except  in  two  particulars  the 
books  are  correct.  If  an  error  has  been  made  in  posting  a  debit  to 
John  Jones's  account  when  the  posting  should  have  been  made  to 
John  Smith's  account,  the  trial  balance  will  not  indicate  that  any- 
thing is  wrong,  for  the  trial  balance  shows  simply  whether  a  suffi- 
cient amount  has  been  debited  somewhere ;  if,  on  the  other  hand, 


38  ACCOUNTS 

John  Jones  has  been  debited  when  he  should  have  been  credited.- 
the  trial  balance  will  show  that  something  is  wrong.  If,  again,  a 
wrong  amount  is  debited  to  some  one,  the  trial  balance  will  not 
indicate  error  provided  the  error  extended  to  the  other  half  of  the 
entry  and  made  the  credit  correspond ;  but  if  the  error  was  made 
in  one  half  of  the  entry  and  not  in  the  other,  the  trial  balance  will 
show  that  something  is  wrong.  All  this,  however,  is  on  the  assump- 
tion that  the  trial  balance  correctly  represents  the  books.  To  draw 
up  a  trial  balance  from  a  big  ledger  and  make  it  prove,  even  when 
the  books  are  right,  is  no  easy  task.  In  the  first  place,  it  is  easy 
for  one  to  skip  some  ledger  account  entirely,  by  merely  overlooking 
it,  for  often  several  accounts  are  on  a  page.  Three  other  errors  are 
common:  in  figuring  a  balance  from  the  ledger;  in  transferring 
figures  from  the  ledger  to  the  trial  balance;  in  footing  the  trial 
balance.  Of  course,  these  errors  should  not  be  made,  but  when 
nothing  more  serious  than  a  mere  test  hinges  upon  such  errors,  a 
bookkeeper  is  strongly  tempted  to  hurry  unduly  and  find  ultimately 
that  haste  has  made  waste. 

When,  therefore,  a  trial  balance  fails  to  prove,  "to  come,"  "to 
be  got,"  as  the  satisfactory  condition  is  variously  expressed,  the 
bookkeeper's  first  business  is  to  see  that  it  correctly  represents  the 
ledger,  —  is  footed  correctly,  has  balances  correctly  transferred 
to  it,  is  based  on  correct  figuring  of  balances,  and  includes  all  open 
ledger  accounts.  In  the  search  for  error,  sometimes  a  clue  may  be 
found.  If  the  difference  between  the  debit  and  the  credit  footings 
is  divisible  by  two,  there  is  a  possibiHty  that  an  account  of  half 
the  amount  has  crept  upon  the  wrong  side  of  the  trial  balance,  for 
of  course  an  item  on  the  wrong  side  makes  that  side  too  large  and 
leaves  the  other  side  too  small,  and  the  difference  between  the 
sides  is  twice  the  amount  of  the  error.  A  mere  glance  up  the  trial 
balance  to  see  whether  there  is  any  item  of  half  the  discrepancy 
is  worth  while,  for  if  such  be  found  upon  the  wrong  side,  —  and  a 
glance  will  usually  indicate  sufficiently  to  the  bookkeeper  on  which 
side  of  an  account  the  balance  should  be,  —  the  discovery  of  the 
mistake  brings  the  trial  balance  to  the  desired  condition.  Other 
clues  are  likely  to  suggest  themselves,  —  such  as  a  discrepancy 
showing  in  only  one  figure  of  the  totals,  due  probably  to  an  error 
in  addition.  When  the  bookkeeper  is  satisfied  that  his  trial  balance 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET      39 

correctly  represents  the  ledger,  his  next  concern  is  to  find  the  ledger 
error,  for  such  error  there  must  be.  Clues  may  suggest  points  to 
look  for.  Sometimes  a  quick  comparison  with  last  month's  trial 
balance  shows  suspicious  changes.  The  error  may  be  in  posting 
a  wrong  figure,  in  posting  to  the  wrong  side  of  an  account,  in  add- 
ing various  parts  of  a  complicated  entry  so  that  the  total  posted  to 
one  side  shall  not  be  equal  to  the  total  posted  to  the  other,  in  en- 
tirely neglecting  to  make  some  posting,  or  in  posting  some  entry 
twice.  If  no  clue  leads  to  the  discovery  of  error,  the  last  resort  is 
to  go  over  every  posting  since  the  last  trial,  see  that  it  is  correct, 
check  it  inconspicuously  in  pencil  in  the  ledger  and  its  source  in  the 
journal,  and  then  go  through  journal  and  ledger  to  find  unchecked 
and  therefore  lost  or  duplicated  entries.  If  this  fails,  the  only  thing 
to  do  is  to  begin  at  the  beginning  once  more.  If  again  the  error  fails 
to  appear,  recourse  is  had  to  the  last  trial  balance,  which,  by 
comparison,  must  show  where  the  discrepancy  lies. 

One  thing  is  of  utmost  importance  in  a  business  of  much  conse- 
quence, however,  and  that  is  ultimately  to  get  the  trial  balance  to 
prove  absolutely.  A  failure  to  prove  shows  that  there  is  at  least  one 
error  somewhere;  but  it  may  mean  a  dozen  errors.  It  does  not, 
moreover,  mean  that  the  errors  are  in  magnitude  equal  to  the  discrep- 
ancy in  the  trial  balance,  for  that  discrepancy  measures  merely  the 
balance  of  errors.  A  case  is  known  where  a  discrepancy  of  one  cent 
led  to  the  discovery  of  several  errors,  one  of  which  was  for  fifteen 
thousand  dollars:  the  one  cent  simply  measured  the  difference 
between  the  debit  errors  and  the  credit  errors.  A  trial  balance 
discrepancy  means  simply  one  or  more  unknown  errors  of  unknown 
magnitude ;  and  no  man  is  willing  to  allow  errors  of  that  sort  in  his 
books,  whatever  may  be  the  labor  cost  of  finding  them. 

This  is  a  sense,  then,  in  which  it  is  impossible  to  overstate  the 
value  of  a  trial  balance.  Yet,  as  already  indicated,  there  are  many 
errors  which  a  trial  balance  will  not  hint  at.  Indeed,  a  trial  balance 
may  prove,  and  yet  the  books  may  err  in  the  very  respects  which 
the  trial  balance  is  meant  to  test.  This  can  happen,  however,  only 
when  an  error  is  made  in  drawing  off  the  balance  exactly  offsetting 
the  error  in  the  books.  Such  a  coincidence  is  strongly  against  the 
law  of  chance,  and  at  worst  could  not  be  a  permanent  false  security, 
for  it  would  not  happen  through  several  trial  balances  in  succession, 


40 


ACCOUNTS 


and  soon  one  that  failed  to  prove  would  disclose  the  error  in  the  earlier 
one. 

The  preservation  of  trial  balances  is  likely  to  be  of  use,  for  not 
only  do  they  sometimes  furnish  clues  for  finding  errors  in  the  new 
trial  balances,  but  they  also  preserve  in  convenient  form  a  state- 
ment of  how  each  account  stood  at  convenient  intervals  of  the 
past.   Usually  they  are  taken  monthly. 

Closely  connected  with  the  trial  balance,  because  based  upon  it, 
though  having  an  entirely  different  purpose,  is  the  six-column 
statement.  This  purports  to  present  a  complete  view  of  the  business 
in  summary  form,  showing  property,  liabilities,  profit,  and  loss. 
Such  a  statement  requires  for  its  compilation  nothing  but  the  trial 
balance  with  Hsts  of  property  and  of  unentered  claims  and  debts. 
The  method  is  simply  to  extend  the  figures  of  the  trial  balance  into 
four  new  columns,  one  each  for  resources,  Habilities,  losses,  and  gains, 
combining  with  those  figures  the  lists  above  mentioned.  In  drawing 
up  such  a  statement,  the  bookkeeper  needs  to  have  clearly  in  mind 
the  significance  of  the  various  accounts  that  he  is  deaUng  with. 
External  accounts,  he  must  remember,  always  indicate  either  re- 
source or  liability,  —  debit  balances  showing  resources  and  credit 
balances  showing  habilities.  The  internal  accounts,  he  must  remem- 
ber, are  of  two  classes,  —  property  accounts,  i.  e.,  real,  and  explana- 
tion or  force  accounts,  i.  e.,  nominal.  Real  accounts  with  debit 
balances  indicate  resources,  and  with  credit  balances  indicate  lia- 
biUties ;  and  nominal  accounts  with  debit  balances  indicate  losses, 
and  with  credit  balances  indicate  gains.  Certain  of  these  accounts 
present  no  complications,  and  we  may  well  carry  them  through  such 
a  statement,  taking  arbitrary  figures  that  will  best  serve  our  pur- 
pose. 

Partial  Six-Column  Statement  [cents  omitted] 


I 

15 
13 
76 

74 

21 

22 

9 


Proprietor 
Bills  Pay. 
Bills  Rec. 
J.  Jones 
J.  Smith 
Expense 
Commission 
Cash 


Dr. 

Cr. 

75,000 
25,000 

Resource 

Liability 
75,000 
25,000 

Loss 

36,000 

36,000 

8,000 

5,000 

8,000 

5,000 

17,000 

1,200 

17,000 

1,600 

1,600 

TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  4I 


So  far  the  work  consists  simply  in  extending  every  debit  of  our 
trial  balance  into  another  column,  resource  or  loss  —  according  as 
the  account  is  real,  representing  property,  or  nominal,  representing 
a  destructive  force,  —  and  every  credit  into  either  a  liability  or  a 
gain  column  —  liability  if  the  account  is  real,  representing  a  claim 
against  the  business,  and  gain  if  the  account  is  nominal,  representing 
a  force  producing  profit. 

When  we  come  to  accounts  with  which  an  inventory  or  list  of 
accrued  items  is  connected,  however,  we  find  more  complication. 
We  have  already  worked  out  one  case  of  Merchandise  in  Chapter 
IV.  Let  us  try  another.   This  would  be  treated  as  follows : 


Dr. 


Mdse. 


Cr. 

10,000 


Resource 
20^000 


Liability  II    Loss 


Gain 
30,000 


This  account  is  both  real  and  nominal.  So  far  as  it  is  real,  we  must 
enter  in  our  resource  column  the  stock  on  hand,  determined  by 
**  taking  account  of  stock,"  or  $20,000.  Now  it  follows  that,  if  the 
account  has  already  reahzed  from  sales  $10,000  more  than  the 
goods  purchased  have  cost  it,  and  $20,000  worth  of  goods  is  still  on 
hand,  the  profit  is  $30,000.  For  the  goods  sold,  $30,000  more  was 
received  than  paid ;  or,  to  express  it  in  another  way,  we  have  got 
back  all  we  paid,  plus  $10,000,  and  have  $20,000  worth  of  goods 
remaining.  W>  accordingly  extend  the  $30,000  into  the  gain  column. 
If,  on  the  other  hand,  the  balance  according  to  our  books  were  a 
debit  of  $io,oco  —  meaning  that  we  had  paid  $10,000  more  for 
goods  than  we  had  received  for  goods  sold  —  and  our  stock  on  hand 
were  still  $20,000,  our  gain  would  be  $10,000 ;  for  we  should  have 
still  on  hand  goods  worth  $20,000,  which,  taking  everything  into  con- 
sideration, would  really  have  cost  us  but  $10,000.  The  $20,000  of 
stock  on  hand  is  usually  written  in  red  ink  to  show  that  it  is  taken 
not  from  the  books  but  from  an  inventory  that  does  not  yet  appear 
upon  the  books  —  though  destined  ultimately  to  appear  upon  them. 
A  similar  thing  may  be  true  of  any  other  property  account  even 
when  not  connected  with  buying  and  selling.  If  the  firm  has  certain 
real  estate  which  is  depreciating,  it  may  carry  the  item  through  the 
statement  somewhat  after  this  fashion,  assuming  the  depreciation 
to  be  3%. 

Gain 


Dr. 

Cr. 

Resource 

Liability 

Loss 

Real  Estate 

and  Plant 

54,200 

52^574 

1,626 

42  ACCOUNTS 

Another  account  which  may  include  inventories  is  interest.  In- 
terest is  paid  not  daily,  of  course,  but  at  intervals.  If  a  firm  pays 
on  December  30  a  large  amount  of  interest,  and  knows  that  on 
January  2  a  much  larger  amount  will  be  due  to  it,  a  statement  which 
is  made  on  December  31  neglecting  the  interest  due  on  January  2 
does  not  fairly  represent  the  facts.  That  interest  payable  to  the 
firm  on  January  2,  though  not  yet  due,  has  been  earned,  with  the 
exception  of  the  amount  for  two  days,  on  December  31 ;  and  a 
statement  of  the  business  for  the  year  closing  December  31  should 
take  note  of  it.  Interest  accrued  but  not  yet  due,  both  for  and 
against  a  business,  should  be  inventoried  whenever  a  statement  is 
desired.  Then  the  entry  on  a  six-column  statement  should  be  made 
in  much  the  same  fashion  as  that  already  worked  out  for  Mer- 
chandise. Suppose  here  the  balance  both  according  to  the  books 
and  according  to  the  inventory  is  favorable.  On  the  statement  the 
item  might  show  as  follows: 


Dr.      I      Cr. 

600 


Interest    I  I      000  100 


Resource  I  Liability 


Loss 


Gain 
700 


The  balance  of  earnings  of  interest  as  shown  by  the  books  is  S600, 
and  the  inventory  shows  that  an  additional  balance  of  $100  has 
already  been  earned  by  this  year's  business,  though  that  interest  has 
not  yet  become  due  and  hence  is  not  yet  on  the  books.  The  total 
gain  therefore  is  $700. 

If  now  we  add  to  our  original  items  on  the  six-column  statement, 
as  given  on  page  40,  those  that  we  have  since  worked  out,  i.  e., 
Merchandise,  Real  Estate  and  Plant,  and  Interest,  we  shall  find  our 
totals  of  each  column  as  follows: 


Dr.     I      Cr.      II  Resource 
116,800  I  116,800  II   118,274 


Liability 
105,000 


Loss     I    Gain 
18,626  I  31,900 


The  first  two  columns  here  are  nothing  but  the  trial  balance,  and 
indicate  simply  that  for  every  debit  a  credit  has  been  given.  The 
next  two  show  that  the  property  of  the  business  is  greater  than  its 
liabilities  by  $13,274.  In  these  liabilities,  it  is  to  be  noticed,  is  in- 
cluded the  liabiUty  of  the  business  to  the  proprietor;  hence,  if  the 
property  is  so  much  in  excess  of  the  liabilities,  that  excess  must 
represent  the  earnings  of  the  year.  If  we  wish  to  know  where  that 
property  came  from,  we  look  at  the  nominal  or  explanation  accounts 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  43 


and  find  some  interesting  figures.  Merchandise  earned  $30,000, 
commission  earned  $1200,  and  interest  earned  $700,  or  a  total  of 
$31,900 ;  and  the  cost  of  securing  this  profit  was  $17,000  for  expense, 
and  $1626  for  wear  and  tear  of  real  estate  and  plant,  or  a  total  of 
$18,626.  The  difference  between  the  gains  and  losses,  therefore,  is 
$13,274 — just  the  difference  between  the  resources  and  the  habilities. 
Should  the  difference  between  resources  and  Habihties  equal  the 
difference  between  gains  and  losses?  Inevitably.  The  nominal  ac- 
counts are  kept  solely  to  show  the  causes  of  the  changes  in  the  real 
accounts,  and  hence  they  must  explain  just  as  many  changes  as 
occur :  a  change  cannot  occur  in  a  real  account,  other  than  an  ex- 
change of  one  thing  for  another,  without  a  nominal  account  record- 
ing the  cause  of  the  change.  Hence  the  proof,  by  correspondence 
of  dift'erences,  must  follow.  It  is  well  to  show  the  proof  by  subtract- 
ing the  total  of  the  columns  at  the  bottom  of  the  sheet,  as  follows  : 


Resource  118,274 
Liability  105,000 
Net  Gain        13,274 


Gain  3i>9oo 

Loss  18,626 

Net  Gain      13,274 


For  practical  purposes  this  is  perhaps  sufficient  explanation  of  a 
six-column  statement  and  its  principle,  but  certain  facts  yet  remain 
which  are  of  interest  to  one  who  wishes  something  better  than  a 
rule  of  thumb.  If  the  question  arises,  How  does  it  happen  that  the 
balancing  is  not  thrown  out  by  putting  into  the  six-column  state- 
ment items  not  on  the  books,  such  as  merchandise  stock  on  hand, 
accrued  interest,  and  valuation  of  real  estate?  the  answer  is  that 
these  outside  figures  are  carried  also  through  the  loss  and  gain  col- 
umns, for  the  figures  in  the  loss  and  gain  columns  are  taken  from 
com.bining  the  book  figures  with  the  inventory  figures:  thus  the 
change  affects  both  sets  of  figures  alike. 

Perhaps  a  more  puzzling  problem  to  solve  is  the  reason  for  the 
apparently  erratic  manner  in  which  book  or  trial  balance  figures 
and  inventory  figures  are  combined.  Let  us  try  all  possible  combi- 
nations of  the  books  and  the  inventory  with  respect  to  interest.  The 


following  are  conceivable  cases: 


(Case  i) 
(Case  2) 
(Case  3) 
(Case  4) 


Interest 


f    Dr. 

Cr. 

Resource 

Liability 

Loss 

600 

100 

500 

600 

600 
600 

100 

100 
100 

700 

Gain 


700 
500 


44  ACCOUNTS 

The  correctness  of  the  loss  and  gain  figures  should  be  clear.  In 
case  I,  the  books  show  a  loss,  but  $ioo  will  come  in  later :  hence  the 
net  loss  is  less.  In  case  2,  the  books  show  a  loss,  and  $100  loss  is  com- 
ing later :  hence  the  total  loss  is  greater.  In  case  3,  the  books  show  a 
gain,  but  $100  is  coming  in  later :  hence  the  total  gain  is  greater.  In 
case  4,  the  books  show  a  gain,  but  $100  must  go  out  later :  hence  the 
net  gain  is  less.  The  curious  thing  to  note  is  that  seemingly  unlike 
things  are  added  and  Hke  things  are  subtracted.  In  case  i,  one 
debit,  or  left-hand,  column  of  a  pair  is  subtracted  from  the  other  debit 
column ;  in  case  4,  one  credit,  or  right-hand,  column  of  a  pair  is 
subtracted  from  the  other  credit  column ;  in  cases  2  and  3,  debit 
and  credit  columns  are  added.  This  calls  for  explanation,  since  we 
usually  add  similar  items  and  subtract  dissimilar.  The  explanation  is 
the  rather  abstract  one  that  the  inventory  figures  represent  a  differ- 
ent sort  of  thing  from  the  book  figures.  This  can  best  be  illustrated 
by  a  question.  What  would  you  give  for  what  is  represented  by  the 
$6oc  debit  in  case  i  ?  Clearly  nothing,  for  it  represents  sums  con- 
sumed, paid  out  on  account  of  that  force  in  business  which  we  call 
interest.  What,  on  the  other  hand,  would  you  give  for  what  is 
represented  by  the  $100  in  the  resource  column  ?  It  is  clearly  worth 
$100,  for  it  represents  $100  of  claims  that  can  be  enforced. 

The  book  figures  are  from  mere  nominal  accounts,  and  hence  are 
mere  explanations.  Yet  an  explanation  can  never  be  a  resource. 
The  figure  of  one  hundred  dollars  in  the  resource  column,  then,  is 
not  a  nominal  figure,  but  indicates  the  anticipation  of  a  real  account ; 
for  if  that  one  hundred  dollars  never  comes  in  as  a  real  thing,  it  will 
never  come  in  at  all.  That  expected  real  resource  must  be  explained 
in  the  six-column  statement  now,  for  it  belongs  to  this  year's  earn- 
ings; but,  as  it  has  not  yet  come  in,  it  is  not  included  in  the  trial 
balance.  When  it  does  come  in,  it  will  be  a  credit  to  Interest  and  a 
debit  perhaps  to  Cash :  it  is  now  included  as  a  credit  to  Interest  in  the 
gain  column,  and  is  simply  placed  artificially  in  the  resource  column 
to  show  that  a  real  resource  (probably  expected  cash)  is  explained 
by  the  credit  to  Interest,  though  that  resource  is  just  now  so  intan- 
gible that  it  can  hardly  be  properly  classified.  From  one  point  of 
view,  then,  the  resource  under  Interest  is  not  interest  at  all,  but  is 
some  unknown  real  account  temporarily  called  interest  for  want  of 
a  better  name.   The  figure  of  gain  opposite  Interest,  in  case  3,  for 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  45 

example,  is  not  derived  from  adding  the  $100  in  the  resource  column 
to  the  S6co  in  the  credit  trial-balance  column,  but  from  adding  to  the 
$6co  an  entirely  different  $100  which  the  bookkeeper  knows  will 
ultimately  be  credited  to  interest,  next  year;  and  the  $ico  in  the 
resource  column  is  simply  the  other  half,  representing  a  real  account, 
of  the  expected  credit  to  interest,  and  put  here  simply  because  there 
is  no  more  intelligible  place  to  put  it.  ^ 

The  six-column  statement  as  a  whole  has  now  served  its  chief 
purpose,  —  to  show  a  summary  of  the  business.  Usually  such  state- 
ments are  drawn  up  only  annually.  Then,  since  the  condition  of  the 
business  has  been  carefully  figured  out,  preservation  of  those  figures 
on  the  books,  in  more  durable  shape  than  a  separate  sheet,  is  Hkely 
to  be  desirable.  This  can  be  accomplished  by  embodying  the  con- 
clusions of  the  statement  directly  upon  the  ledger,  that  is,  closing 
the  ledger  accounts  and  bringing  down  the  balances.  Indeed,  this 
is  necessary  if  the  same  books  are  to  be  continued  into  the  coming 
year,  for  the  affairs  of  the  new  year  will  attach  themselves  to  the 
condition  as  it  now  stands  on  the  six-column  statement,  and  if  the 
books  are  to  tell  the  truth  they  must  be  brought  into  accord  with  the 
facts.   The  process  of  doing  this  is  comparatively  simple. 

In  all  bookkeeping  the  method  of  closing  an  account  that  is  not 
naturally  balanced  is  to  produce  an  artificial  equality  of  debit  and 
credit  by  adding  to  the  smaller  side  a  sum  equal  to  the  excess  of  the 
other  side,  and  then  bringing  down  such  excess  as  the  first  entry  of 
the  new  account.   If,  for  example,  cash  account  shows  a  debit  of 

*  It  is  obvious  that  when  it  is  desired  to  enter  upon  the  books  the  details  of  allow- 
ances and  inventories  here  recorded,  the  result  may  be  accomplished  by  opening 
accounts  in  the  ledger  with  the  items  concerned.  For  example,  instead  of  entering  the 
accrued  interest  in  red  ink  under  the  head  of  Interest,  an  account  may  be  opened  with 
Accrued  Interest,  which  may  be  debited,  with  a  credit  to  Interest,  and  the  amount 
may  be  carried  through  the  six-column  statement.  On  the  statement,  then,  the  Ac- 
crued Interest  would  show  as  a  resource  (a  real  account),  and  Interest  would  show 
as  a  gain  (a  nominal  account).  This  plan  avoids  the  theoretical  complication  ex- 
plained above ;  but  it  has  one  disadvantage.  Under  this  plan  the  balance  of  Accrued 
Interest  continues  on  the  books  indefinitely  until  canceled  by  a  new  entry.  So  watch 
must  be  kept  and  an  entry  made  whenever  accrued  interest  becomes  due.  Under  the 
other  plan,  described  in  the  text,  the  payment  of  interest  automatically  wipes  off  the 
item  of  accrued  interest,  for«  going  to  the  same  account,  the  debit  and  the  credit  offset 
each  other.  In  some  lines  of  business,  as  explained  in  Part  II,  it  is  necessary  to  distin- 
guish three  sorts  of  interest,  — Interest  Accrued,  Interest  Earned,  Interest  Due;  but 
the  principle  is  the  same  throughout. 


46  ACCOUNTS 

$17,000  and  a  credit  of  $15,400,  the  excess  of  debit  is  $1600.  An 
artificial  balance  or  equality  is  struck  by  adding  to  the  credit  side 
$1600,  which  should  be  considered  not  as  a  credit  but  as  simply  a 
means  of  recording  the  measure  of  debit  excess.  Then  the  two  sides 
are  added,  the  totals  written  in  the  book,  the  proper  ruHngs  made, 
and  the  debit  excess  brought  down  to  the  new  account,  thus : 


Jan. 


13 

26 


Cash 

Balance 

8000 

00 

Jan.     3 

Sundries 

28 

2000 

Bills  Rec. 

27 

6000 

00 

14 

Sundries 

30 

3000 

Bills  Pay. 

29 

3000 

00 

00 
00 

16 

Bills  Pay. 
J.  Jones 
Balance 

30 
30 

5000! 
5400 
1600 

17,000 

17,000 

Balance 

1600 

Feb. 

The  balance  artificially  inserted,  as  here  $1600  on  the  credit  side, 
should  be  written  in  red  ink  or  have  some  other  distinguishing 
feature,  that  the  eye  may  note  that  it  is  not  an  entry  but  is  placed 
in  the  account  artificially  to  serve  the  purposes  of  balancing.  Strictly 
speaking,  the  $1600  brought  down  to  the  debit  of  the  new  account 
is  not  the  $i6co  written  in  red  ink  on  the  credit  side:  the  $1600  in 
red  ink  is  merely  a  memorandum  to  determine  the  debit  excess,  for, 
since  on  the  books  subtraction  can  never  be  performed,  the  only 
method  of  showing  excess  is  to  show  how  much  must  be  added  to  the 
smaller  side  in  order  to  produce  equality.  Hence  the  $1600  brought 
down  is  simply  the  debit  excess  brought  down  where  it  naturally 
belongs,  in  a  debit  column. 

The  figure  of  totals  of  the  two  sides,  $17,000  in  the  case  above,  is 
not  an  essential,  and  is  often  omitted.  Yet  a  case  is  known  where 
the  omission  of  those  figures  cost  the  loss  of  more  time  than  the 
writing  of  such  figures  in  all  closed  accounts  would  probably  have 
cost  in  many  years.  The  story  is  worth  telling  because  it  illustrates 
several  important  principles  of  careful  bookkeeping.  A  bookkeeper 
had  worked  several  days  over  his  trial  balance,  following  every  clue 
that  he  could  find  and  then  checking  his  work  over.  Everything 
appeared  correct,  but  a  discrepancy  of  $8.40  persisted.  A  friend 
happened  into  the  office,  was  told  of  the  difficulty,  and  volunteered 
a  few  moments'  assistance.  He  began,  with  the  bookkeeper,  to  com- 
pare the  trial-balance  sheet  with  the  ledger.   The  bookkeeper  was 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  47 

about  to  turn  over  a  certain  ledger  page,  on  the  ground  that  it  con- 
tained no  open  accounts,  when  the  friend  remonstrated.  He  no- 
ticed that  the  accounts  were  ruled  as  if  closed,  but  that  the  figures 
of  totals  were  not  written.  A  moment's  figuring  showed  that  one  of 
those  accounts,  though  ruled,  did  not  balance  by  $8.40  —  just  the 
amount  of  the  discrepancy  in  the  trial  balance.  The  bookkeeper 
insisted  that  the  account  ought  to  balance,  for  the  customer  had 
paid  all  that  he  owed.  The  investigation  that  followed  showed  a 
curious  state  of  things.  In  the  settlement  of  the  account  had  been 
included  a  discount  of  S8.40,  which  should  have  been  credited  to 
the  customer ;  but  by  some  chance  the  entry  was  never  made.  When 
the  bookkeeper,  knowing  that  the  account  had  been  settled,  had 
posted  the  cash  payment  that  settled  the  account,  he  proceeded 
without  further  formality  to  rule  the  account  as  closed.  Had  he 
added  the  figures  of  the  account  as  he  should  have  done,  he  would 
have  seen  that  the  account  was  not  balanced,  and  the  omission  of 
discount  would  have  been  discovered.  The  result  was  that  the 
account  of  the  customer  was  related  to  the  trial  balance  as  it  should 
have  been,  though  not  as  the  books  warranted ;  but  the  discount 
account  was  wrong  to  the  amount  of  $8.40,  not  only  upon  the  trial 
balance  but  also  on  the  books.  Although  there  were  two  errors  in 
the  books,  there  was  but  one  absolute  error  in  the  trial  balance. 
It  was  only  because  the  bookkeeper's  friend  was  suspicious  of  such 
slip-shod  closing  of  accounts  that  he  was  able  to  find  the  error. 
There  is  no  knowing  when  the  bookkeeper  himself  would  have 
found  it.  Before  an  account  is  ruled  the  bookkeeper  must  be  sure 
that  it  balances ;  and  he  must  be  sure,  not  by  figuring  the  items  on 
another  piece  of  paper,  but  by  using  the  identical  marks  of  the  pen 
that  he  finds  in  his  ledger,  for  the  marks  on  his  paper  may  not  be 
the  same  as  those  in  his  ledger,  —  as  is  shown  by  the  case  above. 
One  should  never  add  a  column  of  figures  and  then  transfer  the  total 
as  the  footing  of  another  column  of  figures,  even  when  one  thinks 
they  are  alike.  Of  course  the  actual  writing  in  the  ledger  of  the  total 
of  ledger  footings  is  not  essential,  for  correspondence  is  all  that  is 
needed ;  but  the  appearance  of  them  upon  the  page  is  a  satisfaction 
to  the  eye  and  requires  little  labor. 

When  accounts  shall  be  closed  is  a  matter  solely  of  convenience-. 
Sometimes  when  a  settlement  is  attempted  and  some  matter  is  in  dis- 


48  ACCOUNTS 

pute,  convenience  suggests  that  the  amount  in  dispute  be  preserved 
on  the  record  by  the  closing  of  the  account  and  the  carrying  down 
of  the  disputed  balance  as  the  first  item  of  the  new  account.  Often, 
even  at  the  end  of  the  year,  it  is  not  worth  while  to  close  an  account, 
for  the  items  on  it  may  be  so  few  or  so  simple  that  the  account  is 
sufficiently  intelligible  as  it  stands.  It  is  usually  desirable,  however, 
to  close  at  the  end  of  the  year  all  accounts  showing  loss  or  gain, 
and  in  the  case  of  corporations  which  intend  to  pay  dividends  this 
is  practically  necessary.  This  is  most  simply  done  by  transferring 
to  the  ledger  in  red  ink  all  red-ink  items  of  the  six-column  state- 
ment, and  then  transferring  the  balances  of  those  accounts  to  Profit 
and  Loss,  and  ultimately  transferring  the  Profit  and  Loss  balance 
to  the  Proprietor's  account,  to  Dividend  account,  or  to  Undivided 
Profits  account.  This  may  be  illustrated  by  using  the  figures  that 
we  already  have  in  our  six-column  statement,  and  assuming,  for 
simplicity,  that  the  balances  that  we  find  on  the  trial-balance  part 
of  the  statement  happen  to  be  the  only  entries  under  each  account. 
These  will  be  best  understood  if  the  reader,  as  soon  as  he  finds  that 
any  entry  has  been  carried  to  the  Profit  and  Loss  account,  turns 
to  that  account  and  notes  how  the  item  is  there  treated. 

Expense 

I  I  II    i7,ooo|cx3|||  \Profit  b' Lossl   L25  l|      i'/,ooo\oo 


[The  index  figures  in  these  illustrations  will  be  omitted,  except  for  the  new  entries  which  the 
illustrations  are  designed  to  show.  The  page  index  number  in  italics  is  to  show  the  ledger  page 
to  which  the  item  goes,  and,  conversely,  in  the  Profit  and  Loss  account,  below,  it  shows  from 
what  ledger  page  the  item  comes.  The  principle  of  carrying  forward  the  balance  is  the  same 
here  as  in  the  cash  account  (see  page  46).] 

Commission 
\  Profit  ^  Loss    I  L25  \\    r,20o|oo  III  I  |  || i,2oo|oo 


Jan. 


6*  Loss 

L25 

Mei 
30,000 

00 

^NDISE 

30,OC50 

00 
00 

e 

20,000 

Inventory 


10,000  00 
20,ooo\no 


30,000!  00 


[Here  we  find  a  new  type,  though  the  principle  is  the  same.  The  ledger  does  not  ordinarily 
show  the  goods  on  hand,  for  Merchandise  is  a  combined  real  and  nominal  account.  Here  the 
separation  of  the  two  elements  must  be  made.  When  we  close  Merchandise  account,  to  determine 
its  responsibility  to  us  or  ours  to  it,  we  must  clearly  take  into  consideration  the  goods  that  it  still 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  49 


has' on  hand:  we  charged  Merchandise  with  them  originally,  and  we  must  now,  in  making  a 
settlement,  at  least  temporarily  give  credit  for  them.  Their  amount  is  accordingly  written  in 
red  ink  to  show  that  the  item  comes  from  outside  the  books.  When  this  has  been  done,  we  find 
that  the  excess  of  credit  over  debit  is  $30,000,  and  we  know  that  Merchandise  has  yielded  that 
amount  of  profit  —  has  by  that  amount  produced  more  than  it  has  cost.  This  is  transferred  to 
Profit  and  Loss  as  in  the  other  cases.  The  balance  brought  down  for  Merchandise  itself  is  of 
course  simply  the  $20,000  worth  of  stock  on  hand,  with  a  debit  of  which  Merchandise  must 
begin  the  new  year  since  the  warehouse  is  still  responsible  for  it.  To  summarize  this  treat- 
ment of  Merchandise:  the  $20,000  brought  down  as  a  debit  for  the  new  year  is  simply  that  part 
of  last  year's  debit  to  Merchandise  which  the  account,  as  a  property  account,  has  not  yet  got 
rid  of  responsibihty  for;  and  the  $30,000  carried  to  Profit  and  Loss  is  the  profit  on  last  year's 
sales  which  the  account,  as  an  explanation  account,  last  year  recorded.] 


Jan.  I 


Balance 


Real  Estate  and  Plant 
54,200  c 


54,200 


52»574,oo 


Inventory 
Profit  &>  Loss 


L25 


52,574  00 
1,626  00 
54,200  00 


[Here  we  have  a  loss,  caused  not  by  bad  buying  or  bad  selling,  but  by  a  natural  depreciation. 
We  simply  reduce  the  valuation  brought  down  to  the  new  year  —  a  process  called  "writing  off." 


Interest 


Jan.  I 


Profit  &>  Loss 


Balance 


L25 

700 

00 

700 

00 

100 

00 

Accrued 


6ooj  00 

ioo\oo 


[In  this  case  we  have  something  of  a  new  type,  though  again  we  have  the  old  principle.  It 
may  look  at  first  sight  as  if  it  were  unfair  to  ask  Interest  to  begin  the  new  year  with  a  handicap 
of  $100.00  against  it.  When  one  realizes,  however,  that  the  interest  has  been  earned  this  year, 
and  will  come  in  only  next  year,  one  sees  that  next  year's  Interest  is  responsible  to  collect  that 
sum  and  is  properly  charged.  When  that  interest  is  paid.  Interest  will  be  credited;  and  the  diflfer- 
ence  between  that  credit  and  the  debit  balance  carried  over  to  the  new  year  will  properly  represent 
next  year's  earnings  of  interest  on  that  score —  and  that  is  what  next  year's  interest  account  should 
represent. 

Note  that  a  sum  in  red  ink  when  transferred  or  brought  down  always  goes  to  the  other  side ; 
for  its  occurrence  in  red  is  an  indication  that  it  is  inserted  artificially  either  as  a  measure  of  the 
excess  of  the  other  side  —  as  here  with  the  profit  and  loss  item,  —  or  as  an  anticipation  of  an  item 
on  the  same  side  —  as  here  with  the  accrued  item.  When  it  measures  excess,  the  amount  must 
be  brought  down  on  the  side  that  is  in  excess,  i.  e.y  on  the  other  side,  as  is  done  with  the  profit 
and  loss  item  here  when  transferred  to  the  profit  and  loss  account.  When  it  anticipates  an  item 
on  the  same  side,  that  item,  being  anticipated,  must  be  corrected  or  nuUified  whenever  it  shall 
occur,  and  such  nullification  can  be  made  only  by  an  entry  on  the  other  side;  so  here  the  accrued 
item  is  brought  down  to  nuHify  the  credit  to  interest  when  it  shall  occur  on  next  year's  account. 

If  the  accrument  were  against  the  firm,  instead  of  in  its  favor  as  here,  the  item  of  accrument  in 
red  would  be  on  the  debit  side,  of  course,  and  would  be  brought  down  as  a  credit  balance  to  the 
new  year.  Since  in  that  case  next  year  would  have  to  pay  the  sum  for  this  year's  business,  it  if 
right  that  a  o-edit  should  be  given  it  at  the  start  to  nullify  that  apparent  burden.] 


so 


ACCOUNTS 


Profit  and  Loss 


Expense 
R.  E.  &  PI. 

Proprietor 


L21 
Lio 
U 


17,000 

1,626 

13^274 


31,900 


00 
00 
00 
00 


Commission 

Mdse. 

Interest 


L22 

Lii 
L20 


1,200 

30,000 

700 


31,900 


[The  L  with  the  index  page-figure  is  used  here  to  show  that  the  item  comes  not  from  another 
book  but  from  the  ledger  itself.  Transfers  to  this  account,  since  the  items  now  belong  here,  are 
in  black.  Transfers  from  it  are  in  red.] 

Proprietor 


Balance 


88,274 


,274 


Profit  &  Loss 


Balance 


L2S 

75,000 

88,274 

88,274 

[Another  method  of  closing  the  books,  with  the  advantage  of  giving  full  explanations,  though 
it  is  more  laborious,  is  shown  in  Appendix  B,  II.] 

When  all  this  has  been  accomplished,  the  books  are  said  to  be 
closed.  It  is  to  be  noted  that  now,  for  the  first  time  since  the  last 
closing  of  the  books,  do  the  accounts  show  the  actual  condition  of 
the  business.  Profit  and  expense  have  been  going  on  every  moment, 
and  a  dozen  bookkeepers  probably  could  not  write  fast  enough  to 
keep  up  with  the  accruing  of  interest,  the  expiration  of  insurance, 
the  wear  and  tear  of  plant,  the  depreciation  and  the  profit  in  mer- 
chandise. Bookkeeping  does  not  pretend  to  record  all  matters  as 
they  occur,  but  usually  only  as  distinct  elements  reach  their  cul- 
mination. If  the  business  has  a  sole  proprietor,  every  loss  or  gain 
made  on  January  2  is  his  as  much  at  that  time  as  it  is  on  December 
31  when  the  books  are  closed.  It  should  be  remembered,  therefore, 
that  except  when  the  books  have  been  brought  up  to  the  moment  by 
closing  as  indicated  here,  they  do  not  quite  faithfully  report  conditions. 

If  the  business  is  conducted  by  a  corporation,  a  slightly  different 
method  of  closing  will  be  required.  A  corporation  knows  no  stock- 
holders as  individuals:  it  knows  them  only  as  holders  of  stock 
certificates ;  and  hence  accounts  are  kept  not  with  individuals  but 
with  capital  stock,  with  dividends,  with  profits,  and  sometimes  with 
surplus.  When  the  end  of  the  year  has  been  reached  and  a  state- 
ment has  been  made,  the  disposition  of  the  net  earnings  will  deter- 
mine the  bookkeeping  entries.  Dividends  are  usually  declared  some 
weeks  before  they  are  to  be  paid.  In  that  case  the  dividends  owed 
to  stockholders  form  a  liability  of  the  business,  and  the  profit  and 
loss  account,  instead  of  being  closed  out  to  the  proprietor,  as  in 


TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  51 

the  case  above,  is  closed  out,  at  least  to  the  amount  of  the  dividends, 
to  the  dividend  account,  which  will  show  a  credit.  When  dividends 
are  paid.  Dividends  is  debited,  as  responsible,  and  Cash  is  credited. 
If  the  dividends  do  not  require  the  full  amount  of  the  profits,  the 
balance  may  be  carried  to  ''Surplus,"  to  "Undivided  Profits,"  or 
it  may  remain  undisturbed  in  Profit  and  Loss.  Some  remnant 
usually  remains  after  dividends  are  declared,  unless  they  are  de- 
clared in  excess  of  earnings,  for  practically  never  can  the  profit  be 
divided  exactly  by  the  number  of  shares,  and  most  corporations 
desire  to  keep  at  least  a  small  reserve.  The  balance  undivided, 
under  whatever  account  it  appears,  will  show  as  a  credit,  for  it  in- 
dicates stockholders'  profits  intrusted  to  the  business. 

In  case  the  statement  shows  a  loss,  —  or,  in  the  case  of  a  corpo- 
ration, if  the  dividends  exceed  the  profits,  —  the  bookkeeping  is 
equally  simple.  The  profit  and  loss  account  will  show  a  debit,  and 
that  debit  will  mean  that  the  investment  of  the  proprietor  or  of  the 
stockholders  in  the  business  is  less  valuable  than  at  the  time  of  the 
last  closing  of  the  books.  In  the  case  of  the  proprietor,  that  debit 
balance  is  transferred  to  his  account,  and  the  closing  of  that  ac- 
count shows  him  to  have  a  reduced  present  worth.  In  the  case  of  a 
corporation,  the  balance  is  allowed  to  remain  undisturbed,  repre- 
senting the  impairment  of  capital.  Though  not  a  resource  in  the 
ordinary  sense,  this  figure  of  loss,  this  deficit,  is  a  bookkeeping  re- 
source, for  it  enables  the  business  to  satisfy  its  accountability:  it 
furnishes  an  explanation  of  what  has  become  of  the  capital  of  the 
corporation,  just  as  a  receipt  for  an  authorized  payment  for  charity 
is  a  resource  for  an  agent  intrusted  with  property. 

It  is  to  be  noted  that  a  trial  balance  taken  from  the  books  as  they 
now  stand  will  be  very  different  from  the  one  taken  for  the  six- 
column  statement.  Such  a  trial  balance,  moreover,  if  extended  intc 
a  six-column  statement,  will  yield  nothing  for  the  last  two  columns, 
and  for  the  other  two  will  simply  duplicate  itself.  All  the  nominal 
accounts  save  one  —  and  that  one.  Profit  and  Loss  in  the  case  of  a 
corporation,  is  in  a  sense  no  exception  —  have  disappeared.  There 
is  no  longer  anything  to  explain,  for  the  business  has  settled  with  its 
proprietors,  transferring  the  title  to  its  gains  and  rendering  account 
for  its  losses.  All  that  remains  is  simple  liability  to  proprietors  and 
outsiders  on  one  hand,  and  simple  property  with  which  to  meet 


52  ACCOUNTS 

that  liability  on  the  other.  Even  the  profit  and  loss  account,  in  the 
case  of  a  corporation,  now  represents  liability  of  the  business  to  the 
stockholders  because  of  profits,  just  as  Capital  Stock  represents 
its  liability  to  them  because  of  their  investment.  It  is  true,  of  course, 
that  at  all  times  the  profit  belonged  to  the  stockholders,  but  not  until 
now  has  it  been  known  formally  to  be  profit  and  ultimately  assign- 
able to  them. 

The  new  trial  balance  taken  after  the  closing  of  the  books,  then, 
is  simply  a  statement  covering  the  solvency  of  the  business  —  it  com- 
pares resources  and  liabilities,  showing  them  to  be  equal.  How 
sound  a  business  may  be,  however,  is  determined  not  so  much  by 
the  equality  of  the  footings  as  by  the  availability  of  the  resources 
to  meet  the  liabilities.  A  Profit  and  Loss  credit,  representing  the 
undistributed  earnings  available  for  stockholders,  is  an  element  of 
strength  from  the  point  of  view  of  outside  creditors,  for  since  those 
earnings  have  not  yet  been  assigned  to  individual  stockholders,  they 
constitute  resources  to  which  outside  creditors  may  look  for  the 
payment  of  their  claims.  The  exact  significance  of  this  profit  and 
loss  balance  is  important,  but  easily  lost  sight  of  by  one  unfamiliar 
with  accounts.  Even  in  this  new  trial  balance,  taken  after  the  books 
have  been  closed,  it  is  a  nominal  account,  not  a  real  account.  It 
simply  serves  as  a  measure,  or  register,  to  show  how  much  of  the 
property  of  the  business  is  in  excess  of  the  already  recognized  claims. 
It  is  the  margin  of  solvency. 

Trial  balances  taken  after  the  books  have  been  closed,  and  serving, 
as  just  indicated,  to  show  solvency,  are  commonly  called  balance 
sheets,  and  hereafter  will  be  so  designated  in  this  book.  Such  sheets 
are  usually  arranged  not  in  parallel  columns  but  with  the  items 
grouped,  so  that  the  figures  derived  from  the  books  already  illus- 
trated would  look  as  follows : 


Balance  Sheet 

Resources 

Liabilities 

Real  Estate  &  Plant 

52,574 

Proprietor 

88,274 

Bills  Receivable 

36,000 

Bills  Payable 

25,000 

Cash 

1,600 

J.  Smith 

5,000 

J.  Jones 

8,000 

Interest 

100 

Merchandise 

20,000 

118,274 

118,274 

TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  53 

The  nature  of  the  trial  balance,  of  the  various  parts  of  the  six- 
column  statement,  and  of  the  balance  sheet,  may  well  be  summarized 
at  this  point  so  as  to  show  the  relationship  between  them.  The  pur- 
pose of  the  trial  balance,  as  the  name  suggests,  is  to  test  the  accuracy 
of  the  books  —  for  equaHty  of  debits  and  credits.  This  trial  balance, 
moreover,  is  used  as  the  basis  for  the  six-column  statement,  for  it 
shows  exactly  how  the  books  stand  at  the  close  of  business,  —  and 
hence  the  first  two  columns  of  the  statement  are  a  dupHcate  of  the 
trial  balance.  The  next  two  columns  of  the  statement,  showing  re- 
sources and  liabilities  (not  necessarily  as  on  the  books,  but  making 
allowance  for  matters  not  yet  on  the  books),  are  intended  to  show 
the  facts  of  solvency.  The  last  two  columns  of  the  statement,  show- 
ing losses  and  gains  (not  necessarily  as  on  the  books,  but  making  al- 
lowance for  matters  not  yet  on  the  books),  show  the  facts  of  revenue. 
The  only  way  to  make  the  books  serviceable  for  use  next  year  is  to 
bring  them  up  to  the  times  by  entering  upon  them  the  allowances 
indicated  for  the  close  of  the  year  in  the  last  four  columns  of  the 
statement,  and  then  disposing  of  the  net  profit  or  loss  thus  shown. 
This  process  closes  the  books.  A  trial  balance  taken  after  the  books 
are  closed  is  the  balance  sheet ;  and  except  for  the  changes  due  to  the 
disposition  of  profits  it  should  agree  exactly  with  the  second  pair  of 
columns  (resources  and  liabilities)  of  the  six-column  statement. 

One  other  set  of  illustrations,  to  comprise  practically  every  type 
of  allowance  and  a  different  disposition  of  profits  from  that  pre- 
viously made,  may  be  worth  while,  presenting  the  whole  genealogy 
of  the  balance  sheet  in  a  comprehensive  view. 


Trial  Balance 

Dr. 

C 

Cash 

5,500 

Real  estate 

20,000 

Merchandise 

17,000 

Expense 

8,000 

Commission 

700 

Interest 

500 

Rent 

300 

Capital  stock 

50,000 

51,000 

51,000 

54 


ACCOUNTS 

Six-Column  Statement 


[By  the  books] 

[Solvency  facts] 

[Revenue  facts] 

Dr. 

Cr. 

Resource  Liability 

Loss 

Gain 

Cash 
Real  estate 

5,500 
20,000 

*^ 

5,500 
19,500 

1 

500 

Merchandise 

17,000 

35,000 

18,000 

Expense 

Commission 

Interest 

8,000 
500 

700 

1,200 
250 

700 

6,800 
600 

950 

Rent 

300 

2^ 

200 

2^ 

100 

Capital  stock 

51,000 

50,000 
51,000 

-1  s 

61,450 

50,000 
50,300 

7,900 

19,050 

a 

50,300 

h^ 

7,900 

Net  gain 

11,150 

Net  gain 

11,150 

[Since  in  closing  the  books  at  this  point  the  allowances  are  entered  and  the 
loss  and  gain  items  are  closed  out  to  dividends  and  surplus,  the  obsolete  valua- 
tions and  the  old  revenue  facts  are  removed  from  active  standing  and  only  those 
that  pertain  to  the  new  year  remain  as  balances.  For  instance,  $8000  was  spent 
last  year  on  account  of  expense,  but  $1200  of  that  is  found  now  to  be  uncon- 
sumed  (perhaps  unexpired  insurance,  as  no  separate  account  is  kept  for  in- 
surance), and  so  $1200  properly  belonging  to  next  year,  though  spent  this 
year,  is  brought  down  as  a  balance  for  the  new  year  to  carry.  Conversely, 
though  $300  was  collected  for  rent  last  year,  only  one  third  of  that  has  expired, 
and  $200  of  it  belongs  to  next  year.  That  amount  is  brought  down  as  a  bal- 
ance to  the  credit  of  the  new  year.  Since,  moreover,  the  new  year  has  been 
given  that  credit,  it  is  responsible  to  supply  the  equivalent,  and  hence  on  the 
balance  sheet  this  amount  is  a  liability:  to  put  this  somewhat  differently,  since 
the  old  year  turns  over  to  the  new  all  receipts  (such  as  the  balance  of  cash  col- 
lected from  that  rent),  the  new  year  must  be  held  accountable  also  for  the  equiv- 
alent —  to  supply  the  quarters  or  to  refund  the  money.  When  a  new  trial  bal- 
ance is  taken  of  the  books  as  they  now  stand  closed,  the  result  is  as  follows:  J 


Balance  Sheet 

Resources 

Liabilities 

Cash 

5,500 

Interest 

IOC 

Real  estate 

19,500 

Rent 

200 

Merchandise 

35,000 

Capital  stock 

50,000 

Expense 

1,200 

Dividends 

5,000 

Commission 

250 

Surplus 

6,150 

61,450 

61,450 

TRIAL  BALANCE,  STATEMENT,  AND  BALANCE  SHEET  55 

We  have  now  seen  the  full  meaning  of  two  of  the  three  principles 
of  bookkeeping  —  the  significance  of  debit  and  credit,  and  the 
difference  between  nominal  and  real  accounts  —  and  may  well 
summarize  them.  Since  debit  records  responsibility  taken  and 
credit  records  responsibility  conferred,  and  since  no  transaction  can 
take  place  without  a  responsibiHty  both  taken  and  conferred, 
though  by  different  persons  or  properties  or  forces,  the  debits  must 
equal  the  credits  not  only  for  each  transaction  but  for  all  transac- 
tions. This  gives  us  the  trial  balance  —  which  records  in  classified 
order,  from  the  ledger,  the  items  getting  into  the  books  of  original 
entry  in  chronological  order.  Hence  nothing  can  get  into  the  trial 
balance  except,  through  the  ledger,  from  the  books  of  original  en- 
try or  from  closing  allowances  that  affect  both  debit  and  credit. 
Accounts  are  of  three  sorts,  property  or  claim  (representing  prop- 
erty in  the  business  or  claims  of  it  or  against  it) ,  force  (represent- 
ing forces  of  business  that  cause  it  gain  or  loss),  and  proprietorship 
(representing  what  the  proprietors  have  invested,  plus  any  profits 
accumulated  but  not  yet  withdrawn).  In  a  sense,  the  last  two 
classes  are  identical  in  nature,  though  they  are  different  in  form; 
for  a  gain  or  loss,  explained  by  a  force  or  nominal  account,  shows 
an  increase  or  decrease  in  proprietorship  —  for  w^hose  gain  or  loss 
is  it  but  the  proprietor's  ?  The  difference  in  form  between  these 
two  sorts  of  accounts,  however,  is  wide,  in  that  they  bear  titles 
having  no  apparent  relation.  At  a  certain  stage  in  the  bookkeep- 
ing processes  this  difference  in  form  disappears  and  the  fact  of 
ownership  is  disclosed  under  some  title  that  suggests  it.  This  stage 
is  that  of  closing  the  books.  Then  the  two  classes  of  transactions  — 
those  which  involve  exchanges  of  values  but  no  changes  in  values, 
and  those  which  involve  changes  in  values  but  no  exchanges  — 
come  to  a  final  reporting  and  summary.  The  exchanges  result  in 
transfers  of  items  from  one  property  or  claim'^account  to  another, 
as  the  exchange  of  cash  for  a  note  or  of  merchandise  for  cash,  and 
hence  do  not  affect  the  volume  of  net  assets  —  or  the  excess  of 
assets  over  outside  liabilities,  which  is  proprietorship  —  though 
they  do  affect  the  amount  of  particular  assets  and  Habilities  on  the 
balance  sheet.  The  change  transactions,  however,  involve  a  prop- 
erty or  claim  account  on  one  side  and  a  force  or  nominal  account 
on  the  other,  and  hence  bring  in  property  or  claims  without  direct 


S6  ACCOUNTS 

outgo  or  cause  them  to  go  out  without  direct  income  —  and  so 
affect  proprietorship  or  excess  of  assets  over  outside  liabilities. 
Since  the  purpose  of  closing  the  books  is  to  show  final  results,  and 
the  final  fact  about  all  force  accounts  is  the  effect  on  proprietor- 
ship, these  accounts  are  closed  to  some  proprietorship  account. 
This  is  why  the  balance  sheet  is  exactly  like  the  resource  and  lia- 
bility columns  of  the  six-colvunn  statement  except  in  one  respect: 
this  respect  is  the  balance  of  profit  or  loss  shown  on  the  balance 
sheet  in  some  proprietorship  account;  but  this  balance  of  profit  and 
loss  is  the  same  as  the  last  two  columns  of  the  six-column  state- 
ment; and  hence  the  whole  six-colimm  statement  goes  into  the 
balance  sheet  —  but  with  translated  terms  and  with  cancellations 
of  losses  against  gains.  The  proprietorship  accounts  may  be  many 
in  number,  as  Partners,  Capital  Stock,  Undivided  Profits,  Surplus, 
Dividends  Declared  —  or,  as  an  offset  to  the  capital  which  has  been 
depleted  but  cannot  be  reduced  on  the  books  because  the  stock 
certificates  are  actually  outstanding.  Deficit.  This  proprietorship, 
though  a  liabiHty  in  the  bookkeeping  sense,  is  not  a  Hability  that 
must  be  legally  met.  A  business  may  be  solvent  and  yet  have  noth- 
ing with  which  to  pay  back  what  it  has  received  from  its  proprie- 
tors. Solvency  is  concerned  with  outside  creditors  only,  or  with 
proprietors  in  relations  with  the  business  independent  of  their  in- 
vestment in  it.  Finally,  every  item  once  on  the  books  is  there  to 
stay  xmless  removed  by  cancellation  against  other  items  or  with- 
drawn through  proprietorship;  for  (exchanges  will  shift  the  form 
of^assets  or  HabiHties,  though  they  will  not  affect  the  net  results, 
but  change  or  proprietorship  transactions  will  increase  or  decrease 
the  net  results. 


CHAPTER  SIX 


LABOR-SAVING   DEVICES 


The  most  obvious  improvement  that  can  be  made  over  the  primitive 
books  described  in  Chapter  III  is  a  combination  of  the  day-book  and 
the  journal  in  one  book.  No  purpose  is  served  by  their  separation. 
At  least  the  turning  of  pages  may  be  saved.  When  the  combination 
has  been  made,  the  combined  book  is  usually  known  as  the  journal. 
The  simplest  combination  is  made  by  v^riting  the  journal  entry,  or 
"journalization,"  as  it  is  commonly  called,  directly  beneath  the 
day-book  entry.  This  is  also  the  most  logical  combination,  for  a 
bookkeeper  would  naturally  wish  to  have  the  detailed  history  be- 
fore him  when  he  is  journalizing.  One  difficulty  with  this  arrange- 
ment is  that,  in  posting,  the  eye  of  the  bookkeeper  must  be  careful 
to  detect  exactly  where  the  journal  entry  begins,  or  he  may  omit 
some  item  from  the  ledger.  This  extra  care,  in  separating  the  day- 
book portion  of  the  entry  from  the  journal  portion,  means  less 
rapidity  in  posting.  A  more  common  form  of  combination,  there- 
fore, puts  the  journalization  first,  with  the  day-book  entry  immedi- 
ately beneath.  The  following  may  serve  as  an  illustration : 

May  30 
Sundries 

To  Sundries 
Henry  Esmond 
Interest 

Mdse. 

Delivery  Equipment 

Bills  Receivable 
Sold  Henry  Esmond  the  following: 

100  M.  Cedar  shingles  fi@s 

Second-hand  wagon  and  harness, 

from  stable 

I.  Jay's  note  for  $500  dated  Apr.  30, 
on  3  mos.  (less  discount  $5.00) 
taken  over  by  him  495.00 


63 
20 
II 
12 
13 


300.00 


217.00 


300 
217 

500 


58  ACCOUNTS 

Here  no  delay  is  suffered  in  posting,  for  the  bookkeeper  finds  con- 
spicuous the  items  that  he  wishes  to  post. 

Still  a  third  form  of  combination  is  in  use.  This  consists  of  a 
parallel  arrangement,  and  can  be  well  illustrated  by  the  transaction 
just  given  in  the  other  form. 


May  30 

63 

Henry  Esmond 

Sold  him: 

II 

To  Mdse. 

100  M.  Cedar  shingles /i 
$3.00 

13 

To  Bills  Rec. 

I.  Jay's  note,  4/30,  3  mos., 
taken  over  by  him,    . 

20 

Interest 

less  discount 

12 

ToDeliv.  Equipment  Wagon   and   harness  from 

stable 

1,012 


00 


00 


300 


500 


217 


[Interest  is  debited  here  because  Interest  was  credited  when  the  note  was  ori- 
ginally taken,  on  the  ground  of  expected  profit,  and  now  that  the  chance  of  profit 
is  lost  by  the  taking  up  of  the  note  Interest  must  be  debited  to  offset  the  pre- 
vious credit.] 

This  form  is  much  more  concise  than  the  other,  and  shows  more 
closely  the  connection  between  the  journalization  and  the  detailed 
record,  but  in  such  complicated  entries  as  this  it  is  not  always  easy 
to  arrange  intelligibly.  Credit  items  are  indicated  not  only  by  the 
position  of  the  amount,  in  the  right-hand  figure  column,  but  also 
by  the  word  "to"  prefixed  to  the  name  of  the  account.  For  simple 
transactions,  such  as  the  receipt  of  a  note  or  the  allowance  of  a  dis- 
count, —  and  in  practice  most  journal  entries  are  of  that  sort,  — 
this  form  is  very  convenient,  and  is  coming  to  be  widely  used. 

The  next  step  in  the  saving  of  labor  is  an  important  one,  for  it 
embodies  a  new  principle  which  may  be  extended  almost  infinitely. 
In  most  mercantile  business,  at  least  two  accounts.  Merchandise 
and  Cash,  are  of  continual  recurrence.  Obviously,  if  the  items  of 
these  sorts  could  be  tucked  away  by  themselves  for  a  while  and 
posted  in  lump  sums,  one  posting  for  perhaps  a  hundred  items,  the 
advantage  would  be  very  great.  This  can  be  accomplished  by  the 
provision  of  special  columns  in  the  journal,  —  one  for  Merchan- 
dise, Dr.,  one  for  Merchandise,  Cr.,  one  for  Cash,  Dr.,  and  one  for 
Cash,  Cr.  All  other  items  would  appear  in  the  usual  columns,  and 
would  be  posted  in  the  usual  way.  Such  a  journal  might  look  as 
follows : 


LABOR-SAVING  DEVICES 


S9 


r 
Si 

!^ 

.a 

3 

8 

oo 

2 

OO 

I20 

oo 

247 

00 

97 

^ 

oo 

12S 

00 

11 

2  OO    1 

2 

00 

9 

9 

■ 

I 

^IZL 

00 

July  21. 


Mdse. 
To  Cash 

Cash 
To  Mdse. 

Bo't  2  Cords  Oak  of 
DaTid  Grieve,  (u^  4 

22 
Retail  sales  at 
yard 

Mdse. 

To  J.  March 

20  C.  Walnut,  @  6 

Bills  Pay. 
To  H.  Barr 

Our  note  of  May  7 
paid  by  him 

Mdse.    Dr. 

Total 

Cash  Dr. 
Mdse.  Cr. 
Cash  Cr. 

1 

ja 

i 

2 

u 

8 

00 

2 

00 

12000 

247 

00 

2 

00 

2 

00 

8 

00 

Joo_ 

377 

00 

_ 

_ 

[This  arrangement  practically  posts,  though  not  in  the  ledger,  Merchandise  and  Cash  merely 
in  the  act  of  entering  them,  and  the  totals  may  be  carried  to  the  ledger  at  the  end  of  the  month 
or  the  page.  Note  that  in  the  check  column,  before  the  names  of  the  accounts,  ledger-page  numbers 
are  not  used  for  Merchandise  or  for  Cash.  It  is  desirable  to  have  all  items  checked,  but  as  these 
are  posted  only  in  total  at  the  foot  of  the  column,  the  post-mark  should  not  appear  except  with 
the  footing.  The  blank  check  mark  is  used  to  show  that  the  bookkeeper  has  looked  to  see  that 
the  item  has  appeared  in  the  proper  special  column.  If  a  figure  should  be  omitted  entirely  from 
a  column,  or  should  go  upon  the  wrong  side,  the  trial  balance  would  go  wrong,  and  so  the  footings 
of  the  merchandise  and  the  cash  columns  are  carried  into  the  general  columns,  and  added  with 
the  other  items,  merely  to  test  the  balance  of  total  debit  and  credit.] 

To  summarize  this  special-column  journal,  or  columnar  journal, 
as  it  is  sometimes  called,  we  find  that  it  is  like  the  ordinary  journal, 
except  that  the  postings  for  two  accounts  are,  by  a  temporary  setting 
aside  of  the  items,  posted  in  totals  only,  those  totals  being  written 
at  the  foot  of  the  journal  page  with  appropriate  explanations.  It  is 
to  be  noted,  of  course,  that  this  temporary  setting  aside  does  not 
always  apply  to  a  complete  entry,  but  only  to  that  part  of  it  which 
is  Merchandise  or  Cash.  If  one  half  of  an  entry  is  Cash  and  the 
other  half  Bills  Receivable  or  the  account  of  a  customer,  the  half  not 
Cash  is  treated  as  usual. 

The  principle  here  used  may  be  applied  to  any  account  and  any 
number  of  accounts.  The  only  limit  is  convenience.  It  would  be 
more  work  to  provide  and  maintain  a  special  column  for  an  account 
having  an  average  of  two  entries  per  page  than  it  would  be  to  post 
those  entries  individually. 


6o 


ACCOUNTS 


It  is  worth  while  to  go  on  and  see  in  what  ways  this  principle  of 
the  special  column  is  commonly  applied  in  business  practice,  for  the 
saving  that  it  has  made  possible  is  almost  beyond  the  belief  of  the 
uninitiated. 

One  application  of  this  principle  is  nearly  universal,  consisting  in 
the  separation  of  the  cash  book  from  the  journal.  The  cash  book 
is  simply  a  supplementary  journal,  containing  nothing  but  entries 
of  which  one  half  is  cash.  In  other  words,  the  two  special  columns 
given  to  Cash  in  the  special-column  journal  are  taken  entirely  out 
of  that  journal  and  kept  in  a  separate  book,  and  with  the  cash  por- 
tions of  each  entry  are  carried  also  the  other  half  of  such  entries  — 
that  is,  the  items  to  be  credited  when  Cash  is  debited,  and  vice  versa^ 
as  can  be  seen  below.  The  idea  of  separation  is  carried  so  far,  also, 
as  to  put  all  Cash,  Dr.  items  on  one  page — the  left, — and  all  Cash, 
Cr.  items  on  the  opposite  page.  Cash  entries  can  now  be  made  very 
simply,  for  no  indication  need  be  made  of  the  fact  that  half  of  the 
entry  is  cash.  The  presence  of  the  entry  on  the  cash  book  shows  that 
Cash  is  concerned,  and  the  page,  right  or  left,  indicates  whether 
Cash  is  to  be  debited  or  is  to  be  credited.  A  cash  book,  accordingly, 
may  look  like  this : 

Left-hand  page]  Receipts 


Aug.  lo 


Balance 

Bills  Receivable 
J.  Jones 
Bills  Payable 
H.  Smith 
Cash,  Dr. 


#327  paid 

His  invoice,  8/2,  paid 
Borrowed  on  ^27 
His  acct.  to  balance 
Total  rec'ts 


[This  space  is  left  blank  for  reasons  explained  below.] 


3»549 

27 

643 

247 

1,000 

2,502 

08 

611 

2,502 

6,051 

35 

6,051 

35 

630 

85 

Balance 

[The  balance  brought  down  for  the  new  month  is  taken  from  the  credit  or  disbursements 
page,  which  see.] 

[Right-hand  page 


Aug.  10 

II 

12 

23 

53 

9 

B.  Robinson 

Disbursements 
Paid  on  acct. 

Bills  Payable 

Paid  #21 

Expense 

Stationery,  H.  M.  &  Co. 

Expense 

Printing,  Minerva  Press 

Freight 

On  invoice,  L.  K.  £f  Co. 

Expense 

Postage,  stamped  envel. 

Freight 

On  invoice,  J.  L.  M. 

K.  Pickard  &  Co. 

Paid  them  in  full 

Cash,  Cr. 

Total  disbursements 

Balance 

1,000 

00 

1,500 

00 

62 

00 

24 

00 

73 

00 

85 

00 

53 

00 

2,623 

50 

5.420 

50 

6jo 

^5 

6,051 

35 

LABOR-SAVING  DEVICES  6l 

The  full  principle  of  this  form  of  book  may  be  summarized  in  a  very 
few  words :  this  book  is  simply  a  part  of  the  general  journal ;  it  con- 
tains all  entries  involving  cash,  and  contains  not  only  the  cash  part 
of  those  entries  but  the  other  half  as  well,  one  writing  of  the  figures 
serving  both  entries ;  the  receipts  page  contains  all  Cash  debits,  and 
hence  all  amounts  appearing  on  that  page  except  the  total  must  be 
posted  to  the  credit  of  the  accounts  named,  for  those  accounts  are 
to  be  credited  for  bringing  in  cash;  of  course  the  contrary  is  true 
on  the  credit  page ;  at  the  end  of  the  month  or  the  foot  of  the  page 
the  total  of  the  receipts  may  be  posted  to  the  debit  of  cash,  and  the 
total  of  the  expenditures  to  the  credit  of  cash. 

It  is  desirable  to  show  the  balancing  of  the  book  by  providing 
that  the  corresponding  totals,  6051.35  in  this  case,  shall  be  on  cor- 
responding Hnes  on  the  opposite  pages.  Yet  it  is  undesirable  to 
leave  blank  lines  on  either  side,  for  in  such  case  no  assurance  ap- 
pears that  items  were  not  or  may  not  be  inserted  after  the  book  was 
balanced.  The  old-fashioned  way  to  escape  the  difficulty  is  to  draw 
diagonal  red  ruling  across  all  blank  lines  left  on  either  page.  This 
is  effective,  but  the  various  slants  of  glaring  red  lines  produce  a  page 
that  is  somewhat  offensive  to  any  one  with  an  eye  for  form.  A 
satisfactory  substitute  is  the  method  employed  here.  The  total  of 
the  short  side,  here  the  debit,  is  taken  on  the  first  blank  line,  and  is 
then  repeated,  as  if  it  were  a  new  total,  on  the  desired  hne  opposite 
the  corresponding  figure  on  the  other  page.  Thus  the  only  blank  lines 
are  left  between  two  totals  that  must  correspond ;  and  any  insertion 
advertises  itself  as  out  of  place.  This  device  is  equally  serviceable 
for  closing  the  ledger,  though  since  the  ledger  is  not  a  book  of  original 
entry,  blank  spaces  are  not  necessarily  to  be  avoided. 

Many  business  houses  do  not  bother  to  post  cash  at  all,  but  when 
drawing  up  a  trial  balance  turn  to  the  cash  book  to  obtain  the 
figure  for  Cash.  The  only  objection  to  this  is  that  the  ledger,  which 
is  theoretically  supposed  to  show  a  full  summary  of  the  business, 
fails  to  do  that  if  Cash  is  omitted.  Only  two  postings  a  month  are 
involved  in  keeping  Cash  in  the  ledger,  and  merely  for  the  sake  of 
completeness  it  seems  well  worth  while  to  post  Cash.  If  Cash  is  to 
be  posted,  however,  care  must  be  taken  that  the  balances  are  not 
posted,  for  those  have  already  once  been  included  in  the  receipts  of 
the  preceding  page  or  period.  On  the  receipts  side  a  separate  column 


62  ACCOUNTS 

for  the  balance  keeps  it  out  of  the  total  until  after  posting  is  done, 
and  on  the  disbursements  side  the  total  may  be  taken  before  the 
balance  is  added.  The  principle  of  closing  and  balancing,  which  is 
the  same  for  the  cash  book  as  for  the  ledger,  has  already  been  ex- 
plained on  page  46.  A  comparison  of  the  cash-book  balance  with 
the  actual  cash  on  hand  is  a  valuable  check  on  error. 

When  a  transaction  involves  several  parts,  of  which  some  are 
cash  and  some  are  not,  it  is  necessarily  divided  between  the  general 
journal  and  the  cash  book.  If,  for  example,  a  customer  pays  his 
bill  in  part  by  cash  and  in  part  by  a  note,  Cash  is  debited  and  he  is 
credited  in  the  cash  book  for  the  amount  of  cash,  and  Bills  Re- 
ceivable is  debited  and  he  is  credited  on  the  general  journal  for  the 
note.  When  both  items  are  posted,  the  customer's  account  shows 
credit  for  the  proper  amount. 

We  have  seen  that  sometimes  both  halves  of  an  entry  may  be 
included  in  totals,  so  that  neither  need  be  posted  by  itself,  —  as 
in  the  purchase  for  cash  and  sales  for  cash  on  the  columnar  journal, 
page  59.  There  fifty  sales  for  cash  would  require  but  two  postings, 
one  total  for  Merchandise,  Cr.,  and  one  for  Cash,  Dr.  This  same 
principle  may  be  applied  to  the  cash  book.  In  the  cash  disburse- 
ments given  on  page  60  are  three  items  of  expense  and  two  of  freight. 
If  such  items  are  frequent,  they  may  well  be  given  special  columns 
so  that  they  will  need  to  be  posted  but  once  each  month.  We  have 
already  by  the  device  of  a  separate  book  or  column  for  cash  pro- 
vided that  at  least  one  side  of  all  cash  entries  may  be  neglected  in 
posting  except  for  monthly  totals;  and  now  we  find  that  so  far  as 
certain  kinds  of  entries  occur  often  enough  to  be  worth  special 
columns,  we  can  provide  that  also  the  other  half  of  those  cash  en- 
tries may  be  posted  in  monthly  totals.  Such  a  special-column  cash 
book  might  look  as  follows,  using  the  items  already  given  on  the 
disbursements  side  of  the  simple  cash  book: 


LABOR-SAVING  DEVICES 


63 


'.  10 

55 

15 

II 

i 

v 

i 

12 

V 

V 

53 

^3 

21 

9 

Disbursements 

Sundries 

Expense 

Freight 

B.  Robinson 

Pd.  him  on  acct. 

I, COO:  00 

Bills  Payable 

Paid    ;f2I 

1,500,00 

Expense 

Stationery,  H.  M.  &  Co. 

62 

00 

Expense 

Printing,  Minerva  Pr. 

H 

00 

Freight 

On  invoice,  L.  K.  &  Co. 

73 

00 

Expense 

Postage,  stamped  envel. 

85 

00 

Freight 

On  invoice,  J.  L.  M. 

53 

00 

K.  Pickard  ^  Co. 

Paid  them  in  full 

2,623 

50 

Freight 

Totals 

126 

00 

126 

00 

Expense 

Totals 

Total  disbursements 

171 

00 

171 

00 

Cash,  Cr. 

5420 

50 

Balance 

630 

si_ 

6,051 

35 

[The  use  of  check  marks  here  is  the  same  as  has  already  been  explained  in  connection  with  the 
special-column  journal.  In  this  type  of  book,  if  cash  is  to  be  posted,  the  transference  of  the  totals 
of  special  columns  to  the  general  column  is  a  necessity,  not  a  mere  convenience  as  in  the  special- 
column  journal,  for  here,  unless  these  totals  are  included  in  the  general  column,  the  total  credit 
to  Cash  will  not  be  adequately  stated. 

The  same  general  principle  of  special  columns  is,  of  course,  applicable  to  the  receipts  side  of 
a  cash  book:  a  special  column  might  there  be  useful  for  Bills  Receivable,  for  example. 

It  is  desirable  not  only  in  this  book  but  in  others  that  the  column  for  ledger-folio  numbers 
shall  be  full  when  posting  is  finished,  with  blank  checks  if  no  others  are  required,  for  then  the  eye 
sees  at  a  glance  that  the  posting  for  that  page  is  complete.] 

Similar  to  the  cash  book  in  principle  are  two  books  for  merchan- 
dise, corresponding  exactly  to  the  Merchandise,  Dr.  and  Merchan- 
dise, Cr.  columns  of  the  special-column  journal.  The  book  for 
Merchandise  debits  is,  of  course,  the  invoice  or  purchase  book,  and 
that  for  Merchandise  credits  is  the  sales  book.  These  are  very 
simple  in  form.  In  each  book  a  record  is  made  of  the  purchases  or 
the  salts,  showing  at  the  head  of  each  item  the  name  of  the  business 
house  to  be  credited  or  debited,  and  showing  in  a  column  kept  clear 
for  the  purpose  the  net  amount  of  each  invoice  or  sale.  In  posting, 
each  account  is  debited  or  credited  for  the  net  amount  of  the  bill, 
and  at  the  end  of  the  month  the  totals  of  all  bills  are  posted  to 
Merchandise,  —  to  its  debit  or  its  credit  as  the  case  may  require. 

A  sales-book  form  might  look  as  follows  : 

Sundries 
To  Merchandise 

January  i 
97        Silas  Lapham 

25  Tons  Lehigh  Egg  700  17'^  00 

Carried  over  1 75  00 


64 


ACCOUNTS 

84 

Brought  over 
Paul  Pry 
8  T.  White  ash  stove 

6 

CO 

175 
48 

69 

2 

Peter  Stuyvesant 
lo  Cords  Walnut 
Less  5  ^0 
Merchandise,  Cr. 

8 

GO 

8o 
4 

CO 

oo 

76 

II 

299 

00 


[The  only  precaution  required  here  is  to  see  that  nothing  but  net  amounts 
gets  into  the  last  column.  Subtraction,  such  as  in  the  charge  to  Peter  Stuyvesant, 
should  never  be  done  there,  for  the  total  of  everything  in  the  column  is  the  credit 
to  Merchandise,  and  the  bookkeeper  in  posting  the  debit  items  will  look  in  this 
column  for  the  amount  to  be  charged  to  the  customers. 

The  purchase  book  is  identical  in  form,  —  though,  of  course,  in  posting, 
Merchandise  is  to  be  debited  and  the  other  accounts  are  to  be  credited.  Many 
business  houses  paste  their  bills  into  their  invoice  books  as  an  easy  way  of 
making  entries:  others  file  their  bills  and  for  the  detailed  entry  in  the  invoice 
book  simply  refer  to  them  by  number.! 

Special  columns  may  be  applied  to  the  purchase  and  the  sales  book 
as  well  as  to  the  cash  book,  of  course ;  but  usually  little  advantage 
would  be  derived  from  such  a  device,  for  unless  most  of  a  firm's 
purchases  are  made  from  a  few  sellers,  or  unless  most  of  its  sales  are 
made  to  a  few  buyers,  the  frequency  of  transactions  with  any 
particular  house  would  be  too  slight  or  the  number  of  special  col- 
umns required  would  be  too  great. 

It  is  obvious  that  the  purchases  and  the  sales  cannot  usually  be 
combined  to  advantage  in  one  book,  as  are  cash  receipts  and  cash 
disbursements,  in  such  a  way  as  to  show  the  balance  on  hand;  for, 
since  purchases  are  at  one  set  of  prices  and  sales  are  at  another,  the 
difference  between  totals  is  not  the  inventory.  As  we  have  already 
seen,  not  even  profit  or  loss  can  be  determined  until  the  inventory 
has  been  learned  by  taking  account  of  stock. 

As  soon  as  our  cash  book,  purchase  book,  and  sales  book  come 
into  use,  our  journal  shrinks  in  ordinary  mercantile  business  to  small 
dimensions.  Only  items  which  are  neither  cash  nor  merchandise 
can  then  go  thither.  There  is  much  for  it  to  do,  however;  for  many 
things,  such  as  payment  of  debts  by  notes,  discounts  not  given  in 
cash,  and  credit  for  services,  can  go  nowhere  else. 

Since  the  books  already  described  are  in  almost  universal  use 
in  mercantile  establishments,  and  since  the  number  of  details  about 


LABOR-SAVING  DEVICES  65 

them  may  seem  to  have  made  a  jumble  of  incomprehensibility 
to  the  uninitiated  mind,  it  may  be  well  to  summarize  the  situa- 
tion as  it  now  appears. 

The  ultimate  destination  of  all  items,  either  individually  or  in 
total,  is  the  ledger;  and  items  get  into  the  ledger  by  posting  from 
the  cash  book,  the  purchase  book,  the  sales  book,  and  the  journal. 
A  compHcated  transaction  may  involve  so  many  parts  that  it  must 
be  divided,  —  possibly  even  into  four  parts,  one  for  each  book ; 
but,  in  any  case,  each  part  must  preserve  a  balance  of  debit  and 
credit,  for  no  item  can  go  into  any  one  of  these  books  without  pre- 
senting in  that  book  a  debit  for  every  credit,  and  vice  versa.  By  the 
mere  fact  of  appearing  on  the  debit  side  of  the  cash  book  an  item 
is  debited  to  Cash  and  is  credited  to  some  other  account  named; 
for  when  the  bookkeeper  posts  his  books,  he  posts  the  total  of  the 
page,  less  the  balance,  to  the  debit  of  Cash  and  posts  all  individual 
amounts  to  the  credit  of  the  accounts  named.  By  the  mere  fact  of 
appearing  on  the  credit  side  of  the  cash  book  an  item  is  credited  to 
Cash  and  is  debited  to  some  other  account  named ;  for,  when  post- 
ing is  done,  the  total  of  the  page,  less  the  balance,  is  credited  to 
Cash  and  the  individual  amounts  are  debited  to  accounts  named. 
By  the  mere  fact  of  appearing  on  the  purchase  book  an  item  is 
debited  to  Merchandise  and  is  credited  to  the  account  named,  for 
the  total  of  the  purchases  is  posted  to  the  debit  of  Merchandise  and 
the  individual  items  are  credited  to  the  accounts  named.  By  the 
mere  fact  of  appearing  on  the  sales  book  an  item  is  credited  to  Mer- 
chandise and  is  debited  to  the  account  named,  for  the  total  of  the 
sales  is  posted  to  the  credit  of  Merchandise  and  the  individual  items 
are  posted  to  the  debit  of  the  accounts  named.  On  the  journal,  too, 
a  debit  item  must  have  its  corresponding  credit,  and  vice  versa; 
but  both  accounts  are  specified,  as  our  journal  now  stands,  for  we 
have  removed  all  the  special  columns  and  carried  them  to  special 
books.  Absolute  correspondence  of  debits  and  credits  is  assured; 
and  the  need  for  this  is  fundamental,  for,  if  it  fails,  something  is 
unexplained,  and  the  purpose  of  accounting  is  not  only  to  record 
changes  in  property  but  to  explain  those  changes.  So  far  as  special 
columns  have  been  introduced  into  special  books  —  as  an  Expense 
column  in  the  cash  book  —  there  is  no  serious  compHcation,  for 
the  special  column  here  means  simply  that  instead  of  posting  each 


(A  ACCOUNTS 

individual  item,  as  individual  items  on  the  cash  book  are  usually 
posted,  these  particular  individual  items  are  lumped  at  the  end  of 
the  month. 

A  moment's  consideration  will  now  show  why  double  entry  does 
not  involve  double  work.  Thirty  items  of  sales  will  require  how 
many  postings  ?  Not  sixty,  but  thirty-one ;  thirty  for  the  customers 
and  one  for  the  Merchandise.  So  far  as  we  use  special  columns, 
moreover,  thirty  items  may  not  require  even  thirty  postings;  for 
if  our  thirty  items  are  cash  expenses,  two  postings  will  do  all  the 
work,  —  one  to  Cash  and  one  to  Expense. 

An  interesting  complication  exists  in  the  use  of  both  a  sales  book 
and  a  cash  book  when  a  cash  sale  is  made.  It  is  always  desired  that 
all  cash  should  go  upon  the  cash  book;  it  is  often  desired  that  all 
sales  shall  go  upon  the  sales  book,  simply  in  order  that  the  record 
may  be  complete  in  one  place.  To  enter  the  item  under  the  usual 
plan,  however,  is  to  cause  it  to  be  posted  twice  to  each  account: 
for  on  the  cash  book  it  will  be  included  in  the  total  receipts  and  hence 
posted  to  Cash,  and  at  the  same  time  will  be  posted,  as  all  individual 
items  are  posted,  to  the  credit  of  the  account  yielding  the  cash,  which 
is  here  Merchandise;  and  on  the  sales  book  it  will  be  included  in 
the  total  sales  and  so  be  posted  as  a  credit  to  Merchandise,  and  at  the 
same  time  will  be  posted,  as  all  individual  accounts  are  posted,  to 
the  account  causing  the  outgo  of  Merchandise,  which  is  here  Cash. 
Thus  both  halves  of  the  entry  are  posted  twice.  This,  however,  can 
be  easily  avoided.  Suppose  we  in  each  case  head  off  one  posting. 
We  can  hardly  with  ease  provide  that  the  item  be  omitted  from 
totals,  but  we  can  provide  that  the  individual  part  of  each  entry 
be  passed  without  posting.  If  at  the  time  of  entry  in  the  cash  book 
we  check  the  item  with  a  blank  check  mark  (y/)  in  the  posting- 
check  column,  it  will  not  be  posted  thence  as  a  credit  to  Merchan- 
dise, and  if  in  the  sales  book  we  check  the  item  in  the  same  way,  it 
v/ill  not  be  posted  as  a  debit  to  Cash.  The  result  is  that  from  the 
cash  book,  the  item,  included  in  totals,  is  posted  to  Cash  and  not 
at  all  to  Merchandise,  and  from  the  sales  book,  included  in  totals, 
it  is  posted  as  a  credit  to  Merchandise,  and  not  at  all  to  Cash. 
Thus  is  the  desired  duplication  avoided.  This  sort  of  use  of  the 
blank  check  (\/)  is  a  great  convenience  in  many  ways. 

Sometimes  two  or  three  accounts  are  kept  with  merchandise, 


LABOR-SAVING   DEVICES  67 

even  when  different  classes  of  goods  are  not  kept  separately.  One, 
called  Purchases,  is  to  be  debited  for  goods  purchased  and  to  be 
credited  for  purchased  goods  returned.  Another,  called  Sales,  is 
to  be  credited  for  goods  sold  and  to  be  debited  for  goods  returned 
by  customers.  Care  should  be  taken  that  goods  received  from  cus- 
tomers be  not  debited  to  Purchases  rather  than  to  Sales;  for  then 
both  Purchases  and  Sales  would  be  overstated  (Purchases  finally, 
and  at  the  wrong  price,  and  Sales  originally,  since  the  goods  were 
never  sold).  This  division  of  Merchandise  is  an  illustration  of  the 
difference  between  bookkeeping  and  accounting,  for  by  it,  though 
profits  and  property  are  no  more  accurately  determined  and  hence 
the  bookkeeping  is  no  better,  the  ratios  and  percentages  of  sales 
and  purchases  are  accurately  preserved  whereas  by  the  simpler 
method  they  are  confused.  The  third  of  these  accounts  serves  no 
purpose  but  convenience.  It  is  called  Merchandise  Inventory,  and 
takes  as  a  debit  the  balance  brought  down  from  the  year  before. 
Otherwise  this  balance  would  naturally  go  to  Purchases.  The  ad- 
vantage of  carrying  it  separately  is  statistical,  for  the  preservation 
of  the  figure  permanently  on  the  ledger  in  a  separate  account  makes 
easy  the  comparison  of  yearly  stocks  over  a  long  period.  The  dis- 
advantage is  that  the  figure  must  remain  unchanged  until  the 
books  are  next  closed,  and  the  trial  balance  is  likely  to  be  mislead- 
ing with  an  account  showing  as  Inventory  a  figure  many  months 
out  of  date.  To  avoid  this  possibility  of  confusion,  the  title  should 
always  bear  a  date,  as  Merchandise  Inventory,  January  i,  191 5. 

So  far  none  of  our  devices  for  labor-saving  has  applied  to  the 
ledger.  Only  one  of  much  importance  is  available.  A  business 
house  having  a  long  list  of  customers  is  Hkely,  from  the  extreme 
volume  of  its  ledger,  to  suffer  delays  in  taking  trial  balances.  It  is 
common  under  those  circumstances  to  put  the  names  of  all  customers 
into  a  special  ledger  (or  as  many  ledgers  as  are  convenient)  and  to 
represent  the  whole  body  of  customers  by  one  account  in  the  general 
ledger,  commonly  called  "Accounts  Receivable."  Such  a  special 
ledger  is  usually  called  a  ''sales  ledger."  A  similar  device  provides 
a  "purchase  ledger,"  and  an  "Accounts  Payable"  to  represent  it  in 
the  general  ledger.  The  treatment  of  these  books  and  these  accounts 
in  the  general  scheme  is  simple.  In  the  first  place,  the  total  of  the 
sales  book  at  the  end  of  the  month,  besides  going  to  the  ledger  as  a 


68  ACCOUNTS 

credit  to  Merchandise,  is  posted  as  a  debit  to  Accounts  Receivable. 
By  this  means,  with  no  more  labor  than  that  of  making  one  posting, 
the  whole  body  of  customers  is  represented  in  the  general  ledger. 
The  amount  to  be  debited  to  each  individual  customer  is  posted  to 
that  individual's  account  in  the  sales  ledger  just  as  previously  it  was 
posted  to  the  general  ledger.  In  the  cash  book,  too,  a  special  column 
is  provided  for  Accounts  Receivable,  and  whereas  the  credits  to 
individuals  on  the  payment  of  their  bills  is  made  in  the  sales  ledger 
just  as  previously  it  was  made  in  the  general  ledger,  the  total  of  the 
Accounts  Receivable  column  is  posted  at  the  end  of  the  month  to  the 
general  ledger,  representing  the  whole  body  of  customers.  It  may 
be  also  desirable  to  provide  a  column  in  the  journal  for  Accounts 
Receivable,  so  that  when  bills  are  paid  by  notes  or  in  any  other  way 
than  cash,  the  two  postings,  one  to  the  individual  in  the  sales  ledger, 
and  one  to  Accounts  Receivable  in  the  general  ledger,  may  be  made 
without  the  confusion  of  requiring  two  postings  from  the  same 
figure.  The  account  called  Accounts  Receivable  is  not  an  absolute 
essential  of  the  division  of  the  ledger  into  parts,  for  without  it  the 
ledger  would  simply  consist  of  two  or  more  volumes.  With  such  an 
account,  however,  the  general  ledger  shows  always,  when  posted  to 
the  time  in  question,  just  what  sums  are  due  the  firm  from  customers 
—  information  which  could  not  be  obtained  otherwise  without  fig- 
uring all  the  accounts  in  the  sales  ledger.  This  account,  too,  serves 
as  a  check  or  test  for  the  correctness  of  the  sales  ledger,  for  the 
balance  of  the  Accounts  Receivable  should  always  be  the  same  as 
the  balance  of  all  the  accounts  on  the  sales  ledger.  Accounts  of  this 
sort  are  commonly  called  "controlling  accounts."  To  summarize: 
the  accounts  of  all  customers  of  the  firm  are  kept  in  the  general 
ledger  in  a  bunch,  as  Accounts  Receivable,  and  the  amount  of  each 
customer's  share  in  the  bunch  debt  is  kept  in  the  sales  ledger  only; 
similarly  kept  are  Accounts  Payable  and  the  purchase  ledger ;  post- 
ing the  bunches  as  totals  of  columns  prevents  extra  labor  from  the 
double  posting. 

This  device  of  controlling  accounts  and  subordinate  ledgers  is 
available  for  many  groups  of  accounts.  When  expenses  are  much 
subdivided,  for  example,  it  may  be  worth  while  to  have  General 
Expense  in  the  general  ledger,  and  a  special  expense  ledger  for  the 
subdivisions.    Then  the  tendency  of  General  Expense  can  be 


LABOR-SAVING   DEVICES  69 

watched  daily,  and  reference  can  be  made  to  subdivisions  when 
necessary,  without  the  labor  of  combining  numerous  small  accounts. 

It  is  to  be  noted  that  posting  to  the  controlling  account  in  the 
general  ledger  is  made  not  from  the  subordinate  ledger,  but  from 
the  same  sources  as  the  postings  to  the  subordinate  ledger:  the  post- 
ing to  the  general  ledger  is  from  the  total  of  a  column  or  group  of 
columns  in  the  books  of  original  entry,  and  the  posting  to  the  sub- 
ordinate ledger  is  from  the  details  of  which  the  total  is  made  up. 
So  the  two  are  parallel  but  made  independently. 

This  is  shown  in  the  following  figures  from  a  cash-book  page : 


Jan.  I 


13 

47 
64 

17 

9 


Receipts 

Balance 

Bills  Rec'ble  #67  Paid 

B.  Sykes         Paid  invoice,  12/1 

B.  Patterson  To  bal.  acct. 

Accts.  Rec.    Total 

Cash,  Dr. 


Accts. 

Rec. 

2,354 

27 

600 

00 

2,700 

00 

400 

00 

1,000 

1,000 

00 

00 

32_7oo 
6,054 

00 
27 

3,700 

00 

[The  credits  to  B.  Sykes  and  B.  Patterson  are  posted  to  the  sales  ledger, 
and  the  total,  or  credit  for  Accounts  Receivable,  to  the  general  ledger.! 

Since  the  general  ledger  only  is  included  in  the  trial  balance,  the 
correspondence  of  debits  and  credits  is  not  thrown  out  by  the  double 
posting. 

One  comment  on  the  whole  system  remains  to  be  made.  The 
modern  passion  for  short-cuts  must  not  be  carried  so  far  that  the 
definiteness  of  the  detailed  portion  of  an  entry,  the  day-book  por- 
tion, shall  be  sacrificed.  One  illustration  will  suffice.  Suppose  a 
man  buys,  in  settlement  of  an  account,  his  debtor's  half-interest 
in  a  piece  of  real  estate,  say  worth  $5000,  and  takes  cash  for  the 
balance  of  the  debt,  say  $2500.  Suppose  now  the  man  buys  from 
some  one  else  the  title  to  the  remainder  of  that  piece  of  real  estate  for 
$5000,  using  in  part  the  cash  received  from  his  debtor,  which  pays 
for  one  half  what  he  buys,  or  one  quarter  of  the  whole  property. 
He  would  be  very  foolish  to  record  that  he  had  received  three  fourths 
of  that  property  from  his  debtor  (though  he  did  receive  one  half 
and  cash  enough  to  buy  another   quarter)  and   had  bought  the 


70  ACCOUNTS 

other  one  fourth  from  the  other  owner.  Such  abbreviation  would 
save  one  entry,  but  it  would  falsify  the  record.  If  the  deeds  should  be 
lost  before  they  were  recorded,  and  it  were  shown  that  the  debtor 
never  owned  more  than  one  half  of  the  property  in  question,  the 
buyer's  books  would  militate  against  him  in  his  claim  to  the  whole 
property.  They  would  indicate  that  he  had  bought  from  the  last 
seller  but  one  quarter  of  the  property  and  had  taken  from  his 
debtor  what  the  debtor  did  not  own.  Transactions  which  are  for 
any  reason  distinct  must  not  be  combined  in  a  way  that  will  destroy 
their  identity. 

Often,  on  the  other  hand,  good  bookkeepers  make  entries  that 
are  known  to  be  false  in  detail,  though  not  in  essential  facts,  if  they 
can  make  the  detailed  explanation  sufficiently  clear  and  can  save 
labor  in  the  process.  A  good  illustration  of  this  is  in  connection 
with  Accounts  Receivable.  Often  customers  are  allowed  discounts 
if  bills  are  paid  within  a  certain  number  of  days.  The  entry  of  a 
payment  of  this  sort  would  naturally  involve  two  transactions, 
recorded  in  two  books,  —  on  the  cash  book  a  credit  for  the  cus- 
tomer and  a  debit  to  Cash  for  the  net  cash  paid,  and  on  the  journal 
a  credit  for  the  customer  and  a  debit  to  Merchandise  Discount. 
These  two  entries  in  two  books  mean  unnecessary  labor.  Several 
devices  are  in  use  for  reducing  it,  and  the  principle  is  worthy  of 
notice.  The  simplest  will  serve  for  illustration  here.  Credit  is  given 
the  customer  for  cash  in  the  usual  way,  but  the  amount  is  given  as 
the  full  amount  of  the  bill  before  discount  was  subtracted,  —  as 
if  the  bill  were  paid  without  discount ;  and  then  on  the  other  side 
of  the  cash  book,  Merchandise  Discount  is  debited,  —  usually  in  a 
special  column  to  save  frequent  postings.  The  net  result  of  these 
two  entries  is  to  make  it  appear  that  the  customer  paid  the  full 
amount  of  the  bill  and  the  cashier  returned  to  him  the  discount; 
and  this  is  for  practical  purposes  true  enough,  especially  when  the 
customary  entries  explain  it,  as  they  do.  An  overstatement  of  facts 
when  the  necessary  subtraction  is  at  hand  does  no  harm :  danger 
lies  in  the  understatement  for  which  deficiencies  cannot  be  supplied. 
Other  methods  of  accomplishing  the  same  result  are  given  in  Ap- 
pendix A,  I. 

All  books  of  original  entry  should  be  so  arranged  that  no  items 
can  be  inserted  after  the  books  are  written  in  natural  order.  Thus 


LABOR-SAVING   DEVICES  7l 

each  cash-book  entry  should  occupy  but  one  line ;  for  if  some  should 
occupy  one  line  and  others  more,  figures  could  be  inserted  on  the 
lines  where  no  figures  originally  appeared.  For  the  same  reason, 
no  blank  lines  should  be  left  between  cash-book  entries.  On  the 
journal,  the  sales  book,  and  the  purchase  book,  however,  blank 
lines  are  not  only  safe  but  desirable ;  for  in  those  each  entry  neces- 
sarily occupies  more  than  one  Hne,  and  a  blank  line,  or  a  line  used 
for  the  date  only,  shows  separation  between  entries  so  that  the  eye 
can  easily  distinguish  them,  and  yet  does  not  allow  space  for  a  fraud- 
ulent insertion. 

For  the  purpose  of  giving  a  comprehensive  view  of  the  various 
books  just  described,  with  their  rulings  and  footings,  and  of  the 
postings  from  them,  the  pages  following  show  the  working  out  of  a 
series  of  transactions  that  involve  virtually  all  common  types  of 
entry.  These  are  shown  in  a  journal,  a  cash  book,  a  purchase  book, 
and  a  sales  book,  with  the  ledgers  and  the  trial  balance.  Use  is 
made  of  special  columns,  and  of  controlling  accounts  with  special 
ledgers.  Any  one  who  has  followed  the  discussions  and  the  forms 
so  far  should  have  no  trouble  in  translating  the  entries  into  trans- 
actions. The  explanation  portion  of  each  entry  in  the  books  of 
original  entry  should  make  clear  enough  just  what  happened.  The 
reader  is  recommended  to  follow  the  transactions  chronologically 
from  book  to  book,  rather  than  to  read  one  book  as  a  whole.  The 
relation  between  the  columns  for  controlling  accounts  and  the 
items  for  subordinate-ledger  accounts  should  be  observed,  with 
the  postings  to  both  general  ledger  and  subordinate  ledger  for  such 
items.  The  posting  of  all  totals  —  like  those  for  special  columns 
and  for  books  as  a  whole  —  is  worthy  of  attention.  Though  the 
transactions  number  forty-six,  the  postings  number  only  fifty ;  and 
yet  double-entry  is  preserved,  the  amounts  for  both  customers  and 
creditors  are  carried  to  both  general  ledger  and  subordinate  ledger, 
and  the  number  of  transactions  is  too  small  to  illustrate  the  full 
effect  of  the  labor  saving. 

It  should  not  be  supposed  that  the  forms  here  shown  are  typical 
of  the  best  forms  in  common  use,  for  such  forms  are  complicated 
not  only  in  arrangement  but  in  content.  These  forms  are  given 
simply  to  illustrate  the  fundamental  principles  of  the  special  col- 
umn and  the  special  book.  If  attempts  were  made  to  show  virtu- 


72  ACCOUNTS 

ally  every  type  of  development  of  these  principles,  as  found  in  mod- 
ern bookkeeping  practice,  the  task  would  require  many  volimies. 
In  Appendix  A,  Part  I,  will  be  found  a  considerable  number  of  such 
developed  types,  suggesting  the  application  of  the  most  common 
and  the  most  serviceable  devices. 


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cj  a,  b£ 


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S2^      ^^  y  % 


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x/^oo  O  M  c* 


76 


ACCOUNTS 


1 60 

164 
166 

160 

80 

so 


PURCHASE  BOOK 


July  2 
W.  S.  Rosecrans      10  days 

100  doz.  #124  28.00    2800.00 

100  doz.  #114  52.00    5200.00 

2 
Cash  (J.  Hooker)  » 

[Details  should  be  shown  as  above  or 
by  invoice  number] 

S 
(Cash)  2 


A.  E.  Burnside 
[Details] 

J.  Longstreet 
[Details] 

Cash 
[Details] 


9 

10  days 

II 
(G.  G.  Meade) 


W.  S.  Rosecrans 

[Details] 
Accounts  Payable,  Cr 
Merchandise,  Dr. 


30 
10  days 


Accounts 
Payable 

[page  i] 
Sundries 

8,000.00 

12,000.00 
14,000.00 

2,000.00 

6,000.00 
12,000.00 

36,000.00 

36,000.00 

54,000.00 

*  The  name  is  given  here  for  memorandum  purposes  only.  Compare  this  entry  with  the  next. 

•  Here,  though  the  purchase  was  for  cash,  credit  is  given  to  the  seller  so  that  the  item  can  be  indexed 
ander  bis  name.  He  is  debited  on  the  cash  book.    The  preceding  purchase  does  not  get  indexed. 


LABOR-SAVING   DEVICES 


77 


SALES  BOOK 


162 

168 

170 

16 

V 

168 
170 

88 
50 


Julys 

p.  H.  Sheridan  30  days 

50  doz.  #103 

13 
G.  B.  McClellan         10  days 
[Details  would  be  shown] 

15 
J.  E.  Johnston  10  days 

[Details] 


28.00 


Bills  Receivable 
[Details] 

Cash 
[Details] 

Cash 
[Details] 

G.  B.  McClellan 
[Derails] 


16 
(W.  S.  Hancock) 

17 
(T.  J.  Jackson) 

24 
(G.  H.  Thomas) 

30 
30  days 


J.  E.  Johnston 

[Details] 
Accounts  Receivable,  Dr 
Merchandise,  Cr. 


30 
Cash  and  30  days  ^ 


Accounts 
Receivable 

[page  i] 

Sundries 

1,400.00 
1,150.00 

400.00 

1,000.00 
1,000.00 

1,200.00 

600.00 

2,400.00 

4,950-00 

4,950.00 

9,150.00 

*  See  Dote  on  this  item  in  the  cash  book. 


78 

ACCOUNTS 

LEDGER 

July  25     Cash 
29       " 

U.  S.  Grant 
2*         15000      July    I  [  Sundries 
2          300  00                      Cash 

[page  2] 

I     39,987  50 
I     30,000  00 

July  31  1  Sundries 

Cash 

I  I  II  62,634150  III  July  31  I  Sundries 

[page  10] 

I  2  II  56,395(20 

Bills  Receivable 


July  I  I  U.  S.  Grant 
16  Merchandise 
26    P.  H.  Sheridan 


July  31  I  Cash 


July    I  I  U.  S.  Grant 
22     Cash 


July  31  I  Cash 


I 

10,000 

00 

July  31 

I 

1,200 

00 

I 

1,400 

00 

July    3  I  Cash 


Bills  Payable 


8,000 


July  9 
10 
18 


Cash 


W.  S.  Rosecrans 

Cash 

Cash 


Real  Estate 

30,ooo|oo  |l| 
6oo|oo  III 


Interest 
65I20  III  July    I 


July  31  I  Sundries  |  i 


Sundries 
10  I  Cash 


Rent 
I      III  July  22  I  Cash 

Merchandise 

54,ooo|oo  III  July  31  1  Sundries 


July  31  I  Cash 


July    I  I  Cash 


July  31  I  Sundries 
31  I  Cash 


July  31  I  Merchandise      j  i 


Expense 
790I00  III 


Furniture  &  Fixtures 

2  II    i,ooo|oo  III  I 


Accounts  Payable 

1  II    8,ooo|oo  III  July  31  I  Merchandise 

2  II   26yOOoloO  III  I 

Accounts  Receivable 

4,95o|oo  III  July  31  I  Sundries 

I      III  31  I  Cash 

Delivery  Equipment 

2  II    i,ooo|oo 

2   II  I30I0O 


I 

8,000 

I 

10,000 

I 

8,000 

[page  16] 


9,400 


[page  24] 
00 
00 
00 

[page  32] 


[page  36] 

I2|50 

34150 

[page  44] 

200I00 

[page  50] 
9,i5o|oo 

[page  60I 
I 

[page  70I 
I 

[page  So] 
36,ooo[oo 

[page  88] 

i,40o|oo 
2,000)00 

[page  96I 


»  It  is  not  usually  necessary 
cash  items  must  come  from  the 


to  designate  the  book,  for  the  explanation  makes  that  obvious ;  e.g, 
cash  book,  and  debits  by  merchandise  from  the  sales  book. 


July    8  I  Cash 
July  24  [  Cash 


LABOR-SAVING   DEVICES 

Wages 

I  2  II      160I00  111  I 


|2 


Profit  &  Loss 

200|00  III  I 


79 

[page  104I 

I  I 

[page  120] 


July   5  I  Merchandise     |  i 


July  13  I  Merchandise 

30  I 


July  IS  I  Merchandise 
30 


July    5  1  Cash 
July  19  !  Cash 


July   9  I  Bills  Payable     |  i 


SALES    LEDGER 

P.  H.  Sheridan  [page  162] 

II    i,4oo|oo  III  July  26  I  Bills  Rec.  |  i  ||    i,4oo|oo 

G.  B.  McClellan  [page  168] 

11    i,i5o|oo  III  July  23  I  Cash  I  i  ||    1,150100 

11    i,ooo|oo  III  I  I      II  I 

J.  E.  Johnston  [page  170] 

II       4oo|oo  III  July  25  I  Cash  |  i  ||       400J00 

II    i,ooo|oo  111  30  I     "  I  I  II       450I00 

PURCHASE    LEDGER 

W.  S.  Rosecrans  [page  160] 

II    8,ooo|oo  III  July    2  I  Merchandise  I  i  ||    8,ooo|oo 

II  I      III  30  I  "  1  I  II    2,ooo|oo 

A.  E.  BuRNSiDE  [page  164] 

II  i2,ooo|oo  III  July    5  I  Merchandise  1  i  ||  i2,oooioo 


J.  LONGSTREET  [page  166] 

I  2  II  i4,ooo|oo  III  July    9  I  Merchandise       |  i  ||  14,000:00 


The  general  ledger  gives  the  trial  balance  as  shown  below.  It 
will  be  noted  that  no  figures  from  the  sales  ledger  and  the  pur- 
chase ledger  appear  in  that  trial  balance.  The  controlling  ac- 
counts, Accounts  Receivable  and  Accounts  Payable,  cover  the 
same  ground  as  these  items.  For  assurance  that  proper  debits  and 
credits  have  been  made  to  the  accounts  in  the  special  ledgers,  how- 
ever, an  abstract  of  each  ledger  is  taken  and  the  total  is  compared 
with  the  corresponding  controlling  account  which  enters  into  the 
general-ledger  trial  balance.  If  the  amounts  correspond,  obviously 
the  subordinate  ledger  accounts  are  as  well  proved  to  be  correct  as 
if  they  themselves  entered  into  the  trial  balance. 


So 


ACCOUNTS 

Trial  Balance 

Dr. 

Cr. 

U.  S.  Grant 

$69,537-50 

Cash 

$  6,239.30 

Bills  Receivable 

3,200.00 

Bills  Payable 

18,000.00 

Real  Estate 

30,600.00 

Interest 

18.20 

Rent 

200.00 

Merchandise 

44,850.00 

Expense 

790.00 

Furniture  &  Fixtures 

1,000.00 

Accounts  Receivable 

1,550-00 

Accounts  Payable 

2,000.00 

Delivery  Equipment 

1,130.00 

Wages 

160.00 

Profit  and  Loss 

200.00 

$89,737-50 

•    $89,737.50 

Abstract  of  the  Sales  Ledger 

Dr. 

G.  B.  McClellan  $1,000.00 

J.  E.  Johnston  550.00 

Trial  Balance  (Accts.  Rec.)  $1,550.00 


Abstract  of  the  Purchase  Ledger 


W.  S.  Rosecrans 

Trial  Balance  (Accts.  Payable) 


Cr. 

$2,000.00 

$2,000.00 


PART  TWO 
THE   PRINCIPLES  OF  ACCOUNTING 


CHAPTER  SEVEN 

THE   DISTINCTION   BETWEEN    CAPITAL  AND    REVENUE 

Perhaps  the  easiest  way  of  stating  the  difference  between  book- 
keeping and  accounting  is  to  say  that  the  purpose  of  bookkeeping 
is  to  show  debts,  both  those  due  by  the  owner  of  a  business  and  those 
due  to  him,  and  the  purpose  of  accounting  is  to  show  profits,  losses, 
and  valuations.  Nobody  is  likely  to  think  that  he  now  has  what  he 
never  had,  but  a  business  man  is  constantly  likely  to  confound  what 
his  business  once  had,  but  no  longer  has,  with  what  it  still  has.  The 
fundamental  purpose  of  all  accounting  processes  is  to  provide  against 
such  confusion;  and  just  here,  more  than  anywhere  else,  does  the 
average  business  man  fail  to  get  from  his  books  what  he  thinks  he 
is  getting.  As  a  part  of  the  same  confusion,  though  the  connection 
is  not  always  obvious,  is  the  ignorance  of  costs  and  returns.  Good 
accounting  will  show  as  nearly  as  possible  the  cost  and  the  return 
from  every  appHcation  of  force  and  from  every  change  of  methods  — 
in  service,  as  in  mercantile  affairs,  and  in  transportation,  or  in  pro- 
duction, as  in  a  factory. 

In  Chapter  IV  of  Part  I,  two  sorts  of  internal  accounts  were  de- 
scribed, the  real  and  the  nominal,  or,  as  they  are  sometimes  called, 
property  accounts  and  explanation  accounts;  and  in  Chapter  V 
emphasis  was  laid  on  the  fact  that  in  determining  profit  for  the  year 
it  is  of  vital  importance  to  distinguish  between  these  two  sorts.  This 
was  shown  by  carrying  out  the  six-column  statement  so  that  figures 
of  the  one  sort  were  extended  into  the  columns  devoted  to  resource 
and  liability,  and  those  of  the  other  into  the  columns  devoted  to  loss 
and  gain.  These  are  mere  bookkeeping  expressions  with  which  the 
average  business  man  has  Uttle  occasion  to  deal,  but  every  man  en- 
gaged in  business  affairs  must,  at  some  time  or  other,  deal  with  these 
things  whether  he  calls  them  by  any  name  or  not.  For  example, 
most  corporations  report  their  business  under  the  head  of  two  state- 
ments, the  first  of  which  is  commonly  called  the  "balance  sheet," 


84  ACCOUNTS 

and  the  other  the  "income  sheet,"  though  each  is  sometimes  called 
by  other  names.  The  balance  sheet  is  simply  a  statement  of  re- 
sources and  liabilities/  or  property  and  claims  (both  favorable  and 
unfavorable) ;  and,  consequently,  it  shows  the  solvency  of  the  busi- 
ness. The  income  sheet,  on  the  other  hand,  shows  earnings  and 
expenses  for  the  year  just  passed,  that  is,  the  sources  of  gain  and  the 
kinds  of  cost  or  loss.  The  balance  sheet  accordingly  represents  the 
real  accounts  as  they  stand  at  the  end  of  the  year ;  and  the  income 
sheet  shows  the  explanation  of  the  changes  in  solvency,  so  far  as 
profit  and  loss  have  produced  them,  during  the  year.  The  balance 
sheet  gives  a  summary  view  of  the  situation  at  a  definite  moment  of 
time :  the  income  sheet  gives  a  summary  story  of  the  last  year  that 
produced  that  situation.  These  two  statements  correspond  exactly 
with  the  two  sets  of  columns  on  the  six-column  statement  into  which 
the  trial  balance  is  extended.  If,  then,  one  desires  to  determine  the 
solvency  of  a  business,  one  must  turn  to  the  balance  sheet ;  but  there 
one  gets  no  information  as  to  earnings  or  expenses.  If,  on  the  other 
hand,  one  wishes  to  determine  profits,  one  should  turn  to  the  income 
sheet ;  but  there  one  can  get  no  information  as  to  ultimate  solvency. 
There  is,  nevertheless,  one  common  element  between  these  two  sheets ; 
this  is  the  figure  of  profit  or  loss  still  remaining  in  the  business  as  an 
element  of  solvency.  If,  for  example,  the  business  has  been  accumu- 
lating a  surplus  of  io%  a  year  for  five  years  as  shown  by  the  last 
five  income  sheets,  the  last  installment  of  it  will  appear  on  the  income 
sheet  accompanying  this  year's  balance  sheet,  and  will  also  be  in- 

^  Some  accountants  favor  making  a  distinction  between  a  balance  sheet  and  a 
statement  of  resources  and  liabilities.  In  their  practice,  a  balance  sheet  would  repre- 
sent figures  taken  directly  from  the  books  without  allowance  for  possible  or  theoretical 
shrinkage  in  values,  whereas  a  statement  of  resources  and  liabilities  would  show  re- 
sults after  such  allowances  had  been  made.  No  exception  can  be  taken  to  such  distinc- 
tion, and  it  is  indeed  desirable  that  it  shall  be  not  only  made  but  published  in  the 
form  of  the  two  tables.  When  but  one  of  these  two  tables  is  published,  however,  it  is 
desirable  that  the  balance  sheet,  rather  than  the  statement  of  resources  and  liabilities, 
shall  be  chosen.  The  advantage  of  this  is  suflBciently  illustrated  by  the  case  of  Bills 
Receivable,  which  must  appear  on  a  true  balance  sheet  at  the  face  value  of  all  the 
notes,  but  must  usually  appear  on  a  true  statement  of  resources  at  a  lower  figure. 
The  objection  to  a  publication  of  the  latter  rather  than  of  the  former  is  that,  since  the 
valuation  is  determined  by  judgment,  and  since  no  two  men  may  judge  quite  alike, 
the  arbitrary  valuation  may  not  be  so  satisfactory  as  a  piece  of  information  for  the 
intelligent  reader  as  would  be  the  face  value  of  the  notes  themselves.  This  is  further 
discussed  in  the  next  chapter. 


DISTINCTION   BETWEEN   CAPITAL  AND   REVENUE       85 

eluded  in  the  surplus,  which  appears  upon  the  balance  sheet  as  one 
of  the  liabilities  of  the  corporation  to  its  stockholders.  We  have 
this  common  element  because  the  year's  transactions  as  shown  by 
the  income  sheet  have  resulted  in  the  situation  shown  for  one  mo- 
ment of  time  on  the  balance  sheet. 

Thus  it  is  obvious  that  no  confusion  can  be  permitted  between 
items  which  are  to  appear  upon  the  balance  sheet  and  those  which 
are  to  appear  upon  the  income  sheet ;  for  if  such  confusion  is  allowed, 
what  was  once  had  is  confused  with  what  is  now  had.  Only  the  bal- 
ance sheet  represents  the  present  condition,  whereas  the  income 
sheet  represents  the  transactions  which  produced  that  condition  but 
ceased  to  have  independence  as  soon  as  they  were  completed ;  for  all 
tangible  results  can  be  measured  in  the  tangible  items  of  the  balance 
sheet.  In  accounting  parlance,  entering  transactions  so  that  they 
shall  appear  upon  the  balance  sheet  is  called  "charging  to  capital," 
and  entering  them  so  that  they  shall  appear  upon  the  income  sheet  is 
called  "charging  to  revenue."  Perhaps  this  can  best  be  illustrated 
by  a  few  examples. 

Suppose  we  are  the  owners  of  a  building.  It  has  been  in  use  as  a 
bowling  alley,  a  skating  rink,  or  a  riding  school,  and  the  movement 
of  business  and  population  requires  that  in  order  to  serve  good 
tenants  it  shall  be  cut  up  into  various  stores.  The  building  is  re- 
modeled, and  the  question  arises  as  to  what  account  shall  bear  the 
charge  for  remodeling.  The  exact  title  of  the  account  is  not  here 
of  importance,  but  whether  it  should  be  charged  to  revenue  or  to 
capital  is  a  matter  of  the  greatest  importance.  Let  us  assume,  for  the 
purpose  of  making  our  illustration  clear,  that  the  alternative  is 
simply  charging  to  Rent  or  to  Real  Estate.^  The  real  estate  account, 
representing  property,  should  represent  on  the  books  the  value  of 
the  building.  The  rent  account,  on  the  other  hand,  since  it  is  nominal, 
should  show  the  earnings  from  rental  less  any  deductions  that  may 
be  necessary  to  secure  that  rent.  It  is  fairly  obvious  that  under  the 
conditions  named  the  cost  of  these  alterations  should  be  charged  to 

^  It  is  intended  to  use  initial  capitals  for  the  names  of  ledger  accounts,  without 
using  the  word  "account."  The  expression  "real  estate,"  therefore,  means  in  the 
following  pages  the  actual  property;  but  the  expression  "Real  Estate"  means  the 
ledger  account  of  that  name.  When,  for  any  reason,  it  happens  to  be  desirable  to 
use  the  word  "account"  in  connection  with  a  ledger  account,  capitals  will  not  be 
used. 


86  ACCOUNTS 

Real  Estate  and  not  to  Rent,  for  the  improvement  is  intended  to  be 
permanent.  Now  let  us  suppose  that  after  one  of  these  stores  has 
been  let  for  a  year  the  tenant  moves.  Another  man  offers  to  hire  the 
store  if  we  will  take  out  the  windows  and  substitute  others  adapted 
to  his  particular  business,  and  he  refuses  to  hire  unless  we  make  the 
change.  Suppose  again  we  charge  to  Real  Estate,  on  the  ground  that 
the  property  is  improved.  In  the  course  of  time  this  tenant  moves ; 
and,  in  order  to  let  the  building  again,  we  are  forced  to  replace  the 
old  windows.  Here,  clearly,  the  question  might  arise  as  to  which 
account  the  alteration  should  be  charged  to ;  but  let  us  suppose  that 
on  the  principle  that  the  alteration  makes  the  building  worth  more 
for  present  purposes  than  before,  the  charge  is  made  to  Real  Estate. 
Now,  in  course  of  time,  business  has  left  that  section  of  the  city. 
Small  shops  succeed  large  stores.  We  cut  the  old  store  into  several 
small  shops  and  charge  to  Real  Estate.  At  the  end  of  this  year  the 
tenants  move  out,  and  we  can  let  the  property  again  by  removing  the 
partitions.  We  make  the  change  and,  as  before,  debit  Real  Estate. 
So  the  thing,  let  us  suppose,  is  repeated  indefinitely.  Each  year  we 
make  some  change  and  the  next  we  undo  what  we  had  done.  Each 
year  we  charge  Real  Estate  for  improvement  in  the  property,  making 
it  each  time  rentable.  What  is  the  result  ?  Our  books  show  a  stead- 
ily increasing  charge  to  Real  Estate,  and  yet  the  property  is  pre- 
sumably even  less  valuable  at  the  end  of  the  time  than  at  the  begin- 
ning. Clearly  this  is  bad  accounting,  and  the  fault  lies  in  the  fact 
that  some  of  these  alterations  were  not  permanent  improvements, 
but  were  mere  costs  of  getting  rent.  They  were  expenses  or  loss,  in- 
curred in  the  process  of  earning  rental.  They  should  have  been  set 
against  that  rental  and  not  considered  as  additions  to  our  property. 
Though  ordinarily  it  would  be  desirable  to  distinguish  between  de- 
ductions from  rent  and  alterations  to  secure  rent,  for  our  purposes 
here  we  may  disregard  such  distinction,  since  both  are  charges 
against  revenue,  and  say  that  the  charges  for  alterations,  in  most  of 
these  cases,  should  have  been  made  to  Rent.  They  were  proper 
charges  to  revenue,  and  not  to  capital  account.  In  other  words,  at 
the  end  of  the  year,  they  should  have  been  extended  on  the  six- 
column  statement  not  into  the  resource  column,  but  into  the  loss 
column.  They  should  go  not  upon  the  balance  sheet  as  resource, 
but  upon  the  income  sheet  as  expense.  They  should  not  be  counted 


DISTINCTION   BETWEEN   CAPITAL  AND   REVENUE       87 

as  investment,  or  capital,  but  should  be  taken  out  of  earnings,  or 
revenue. 

The  last  problem  was  concerned  with  determining  to  which  of 
two  accounts  an  item  should  be  carried.  Let  us  take  another  sort 
of  case.  Suppose  you  are  engaged  in  the  ice  business  and  have  on 
your  ledger  an  account  with  a  certain  ice  house,  charging  that  ice 
house  with  the  cost  of  ice  put  in.  At  the  end  of  the  year  that  ice,  con- 
sidered on  hand  ready  for  the  next  season's  business,  is  a  resource, 
and  is  naturally  carried  into  the  balance  sheet  under  the  title,  we 
will  say,  of  "Silver  Pond  Ice."  Now  suppose  that  in  the  spring, 
before  the  season  has  opened,  a  fire  destroys  the  house,  and,  in  con- 
sequence of  the  heat  and  the  exposure,  the  ice  is  destroyed.^  What 
entry  need  be  made  upon  the  books?  Clearly  no  entry  becomes 
necessary  if,  in  closing  the  books  at  the  end  of  the  year,  you  realize 
that  that  Silver  Pond  Ice  account  is  no  longer  a  real  account,  but 
has  become,  by  force  of  circumstances,  nominal.  It  will  then  be 
carried  on  the  six-column  statement  into  the  loss  column,  and, 
what  is  the  same  thing,  will  be  carried  into  the  income  sheet  as  one 
of  the  losses  rather  than  into  the  balance  sheet  as  one  of  the  re- 
sources. In  other  words,  the  same  account  may  represent  an  item 
upon  either  sheet,  and  its  ultimate  destination  will  be  determined 
by  the  particular  thing  it  represents  at  the  time  the  sheets  are  made 
out.  On  the  books  there  is  no  difference  in  appearance  between  a 
revenue  account  and  a  capital  account.  It  is  only  in  interpreting 
the  figures  at  the  end  of  the  period  that  any  distinction  need  be  made, 
and  then  the  interpreter  must  know  exactly  what  the  account  at  that 
moment  represents. 

Let  us  take  a  third  sort  of  case.  You  are  the  owner  of  a  quarry, 
and  preparatory  to  getting  out  rock  it  is  necessary  to  remove  ''top," 
that  is  to  say,  get  off  the  loose  earth  which  covers  the  valuable  stone. 
Suppose,  for  purposes  of  our  illustration,  that  it  is  convenient  to  re- 
move, before  any  excavation  is  begun,  all  the  top  from  the  bed  of 
rock  to  be  quarried.  Suppose  it  is  known  that  this  particular  bed  of 
rock  will  last  for  four  years.  At  the  end  of  the  first  year  how  shall  the 
cost  of  removing  top  appear  upon  the  books?  Clearly  the  removal 
of  top  is  an  expense  and  must  go  ultimately  into  the  income  sheet. 
It  is  a  cost  of  obtaining  revenue  and  therefore  chargeable  to  revenue 
account.  Yet  three  fourths  of  the  cost  is  as  yet  unutilized  and  is  con- 

*  This  illustration  is  repeated  from  Part  I,  page  12. 


88  ACCOUNTS 

sequently  a  resource  for  the  future.  At  the  end  of  the  first  year, 
therefore,  thiee  fourths  of  this  cost  may  be  counted  as  a  resource,  and 
may  appear  upon  the  balance  sheet ;  whereas  the  remaining  fourth, 
chargeable  to  the  revenue  of  that  year,  must  appear  upon  the  income 
sheet.  Suppose,  now,  to  make  our  illustration  a  little  more  service- 
able, the  bed  of  rock  is  of  a  peculiar  formation,  so  that  in  three 
of  the  four  sections  into  which  the  bed  may  be  divided  there  are 
known  to  be  three  hundred  thousand  tons  of  rock  each,  whereas 
in  the  other  section  there  are  known  to  be  but  one  hundred  thou- 
sand tons,  and  the  section  containing  the  one  hundred  thousand  tons 
is  that  removed  in  the  first  year. 


100,000  Tons 

300,000  Tons 

300,000  Tons 

300,000  Tons 

At  the  end  of  the  year  how  shall  Top-removal  stand  on  the  books  ? 
Clearly,  one  fourth  of  it  has  been  consumed  in  getting  out  but  one 
tenth  of  the  total  amount  of  rock.  Is  it  chargeable  against  one  quar- 
ter of  the  rock  or  against  one  tenth?  That  is  to  say,  shall  we  take 
for  our  basis  of  depreciation  the  total  utilization  of  top-removal,  or 
shall  we  take  the  amount  of  rock  quarried  by  means  of  that  utiliza- 
tion ?  Shall  Top-removal  be  included  in  the  balance  sheet  as  if  the 
fraction  still  serviceable  were  three  fourths  or  as  if  it  were  nine 
tenths  ?  Still  further  information  is  necessary  to  enable  us  to  deter- 
mine this  fraction.  If  in  order  to  reach  the  rock  in  the  three  larger 
sections  it  were  necessary  to  remove  the  top  covering  all  four  sections, 
the  top-removal  now  utiKzed  (that  over  the  small  section)  would  be 
a  direct  cost  chargeable  against  the  full  one  million  tons ;  that  is  to 
say,  only  one  tenth  of  its  serviceability  would  have  been  consumed 
and  nine  tenths  would  remain.  If,  on  the  other  hand,  the  top  over 
the  small  section  has  nothing  to  do  with  quarrying  in  any  other 
section,  as  is  of  course  probable,  one  fourth  of  the  top-removal  has 
been  utilized  and  only  three  fourths  of  the  total  cost  can  be  con- 
sidered an  asset.  So  in  one  case  the  balance  sheet  will  include  nine 
tenths  of  cost  of  top-removal  among  the  assets  and  the  income  sheet 
one  tenth  among  the  expenses,  and  in  the  other  case  the  assets  will 
include  but  three  fourths  and  the  expense  will  be  one  fourth.  This 
difference  is  of  more  importance  than  may  at  first  appear.  One  can- 


DISTINCTION   BETWEEN   CAPITAL  AND   REVENUE       89 

not  be  sure,  just  because  it  will  pay  to  remove  the  top  over  one  of 
the  larger  sections,  containing  three  hundred  thousand  tons  of  rock, 
that  it  also  will  pay  to  remove  the  top  over  the  smaller  section.  It 
might  indeed  happen  that  the  proceeds  from  the  smaller  section 
prove  not  enough  to  pay  for  the  removal  of  top  over  that  section. 
If  that  is  the  fact,  the  books  should  show  it.  Otherwise,  the  books 
are  failing  in  one  of  the  first  purposes  of  all  accounting,  namely,  to 
show  not  only  what  is  the  absolute  profit  or  loss,  but  also  the  source 
from  which  each  portion  comes.  Any  failure  to  charge  cost  against 
the  particular  revenue  for  which  it  is  incurred  sacrifices  information 
that  may  prove  of  great  value. 

It  is  obvious,  from  the  three  illustrations  that  have  been  given,  that 
it  is  not  always  possible  in  making  entries  of  cost  or  loss  to  treat  them 
so  that  at  the  end  of  the  year  they  shall  be  known  at  a  glance  to  be 
exactly  either  revenue  or  capital.  Allowance  must  usually  be  made. 
Nothing  can  be  valued  with  permanent  certainty.  Even  those  things 
in  business  which  seem  most  unchanging  are  subject  to  fluctuations, 
especially  to  depreciation.  Even  a  stone  building  is  worth  less  as 
the  years  go  by ;  and,  therefore,  allowance  must  be  made  each  year 
for  some  depreciation.  It  may  seem  that,  if  in  the  end  so  many  allow- 
ances must  be  made,  it  is  hardly  worth  while  to  attempt  in  the  origi- 
nal entries  to  distinguish  very  exactly  between  revenue  and  capital. 
Some  one  may  say  if  the  allowances  have  got  to  be  made  at  the  end 
of  the  time,  the  original  labor  of  distinguishing  day  by  day  may  as 
well  be  saved.  The  answer  is  that  the  more  carefully  distinction  is 
made  day  by  day  as  original  entries  are  made,  the  more  largely  is  the 
labor  of  making  allowances  at  the  end  of  the  year  reduced  to  a  mini- 
mum. The  accounts  should  be  so  kept  that  they  throw  the  greatest: 
light  possible  upon  the  probable  depreciation  of  each  kind  of  pro- 
perty. It  is  obvious,  however,  that  even  with  the  most  complete  set 
of  books  at  one's  disposal,  if  one  does  not  know  what  each  ledger 
account  represents  one  can  tell  nothing  of  how  the  business  stands 
at  any  particular  time.  A  cost  account  means  a  certain  thing  with 
one  corporation,  but  may  mean  a  different  thing  with  another.  One 
must  know  the  business  significance  in  each  particular  case.  The 
presumption  always  is,  however,  that,  unless  something  is  known 
to  the  contrary,  certain  common  accounts  stand  for  certain  definite 
things :  that  is  to  say,  Rent,  Interest,  Wages,  Commission,  Insurance, 


90  ACCOUNTS 

etc.,  are  revenue  accounts;  and  Real  Estate,  Bills  Receivable, 
Accounts  Receivable,  and  Merchandise  are  capital  accounts. 

Roughly,  we  may  say  that  whatever  is  expected  to  exist  as  an  asset 
at  the  end  of  the  current  earning  period  should  be  charged  to  cap- 
ital, and  whatever  is  expected  to  be  consumed  during  the  earning 
period  should  be  charged  to  revenue.  This  means,  of  course,  that 
expenditures  which  contribute  to  assets,  even  though  the  direct 
result  of  the  expenditure  seems  to  disappear  immediately,  should 
be  charged  to  capital.  The  wages  of  a  night  watchman  engaged  in 
protecting  a  building  under  construction,  for  example,  are  charge- 
able to  capital,  though  apparently  no  atom  of  value  is  added  by  his 
attention;  for  his  task  is  to  protect  from  theft  the  value  already  pro- 
duced, and  since  society  is  so  constituted  that  this  is  an  essential 
of  production,  its  cost  is  a  capital  charge. 

So  far,  expense  and  loss  have  been  mentioned  only  in  connection 
with  some  particular  year's  business,  —  that  is,  as  if  they  could  go  only 
into  the  loss  column  of  the  six-column  statement  and  into  the  income 
sheet.  It  is  possible,  however,  to  take  the  loss  out  of  the  earnings 
of  no  particular  year.  If  the  loss  has  been  inevitable  and  general, 
touching  the  business  as  a  permanent  institution  and  not  simply  as 
a  momentary  thing,  the  charge  may  well  be  made  to  some  account 
representing  accumulated  profits  of  the  past.  That  is,  the  charge 
would  be  made  not  to  some  account  that  is  closed  out  at  the  end  of 
the  year  to  Loss  and  Gain,  and  thus  extended  into  the  income  sheet, 
but  directly  to  the  general  profit  and  loss  account  or  other  undivided 
profits  account  that  never  appears  on  the  income  sheet;  thus  it  would 
not  appear  anywhere  in  the  expenses  of  the  particular  year  in  which 
it  occurs.  Illustrations  of  proper  cases  for  such  treatment  would  be 
the  cost  of  repairs  after  an  earthquake,  and  rebuilding  after  an  ex- 
tensive conflagration  such  that  insurance  companies  were  not  able  to 
meet  their  Uabilities.  A  word  of  explanation  of  such  charges  should 
be  given  in  the  annual  report,  preferably  in  the  form  of  a  statement 
of  changes  in  Profit  and  Loss,  or  in  Surplus. 

A  similar  principle  applies  to  gains.  If  property  other  than  mer- 
chandise (which  is  goods  bought  for  sale)  is  sold  at  a  gain,  the  gain 
is  not  usually  either  a  gain  of  the  period  in  which  the  sale  was  made 
or  properly  a  revenue  gain  of  any  period.  If,  for  example,  a  fac- 
tory outgrows  its  quarters  and  sells  its  real  estate  at  a  gain  over 


DISTINCTION  BETWEEN  CAPITAL  AND   REVENUE      9I 

cost,  because  of  changes  in  demand  for  real  estate,  the  gain  does  not 
arise  from  doing  business,  and  hence  is  not  a  gain  of  revenue :  the 
capital  of  the  business  has  increased  independently  of  operations 
connected  with  the  function  of  the  business;  so  the  gain  should  not 
appear  on  the  income  sheet  but  among  the  changes  in  Profit  and 
Loss  or  in  Surplus.  Gain  on  owned  stock  and  bonds  sold,  when 
dealing  in  stocks  and  bonds  is  not  a  part  of  the  business,  is  of  the 
same  nature.  Premium  on  bonds  and  stocks  issued,  however,  is 
not  properly  a  gain  at  all,  and  hence  is  not  so  treated:  it  will  be  dis- 
cussed later.  Capital  gains  are  not  usually  distributable  as  divi- 
dends. Unless  they  are  so  distributable  —  both  as  a  matter  of  law 
and  as  a  matter  of  policy  —  they  should  be  credited  not  to  general 
Surplus,  but  to  a  special  Capital  Surplus  account.  Otherwise  divi- 
dends may  be  inadvertently  declared  from  them. 

Below  will  be  found  figures  from  a  report  of  the  United  States 
Steel  Corporation. 


Balance  Sheet 

Assets 

Liabilities 

Property  (Real  estate, 

Capital 

stock 

$868,607,000.00 

plant,  etc.)                           $i 

,353.907,945-68 

Funded 

and  mortgage  debt 

566,388,375.96 

Mining  royalties,  etc.,  paid 

Current  liabilities 

43,672,009.34 

in  advance 

1,772,621.94 

Special  funds 

104,921,669.74 

Investments  (outside  real 

Surplus 

97,720,714.35 

estate,  etc.) 

1,617,351.29 

Special  funds 

27443,944.60 

Current  assets  (inventories, 

cash,  claims,  etc.) 

266,567,905.88 
,681,309,769.39 

I 

1,681,309,769.39 

Income  Sheet 

Gross  receipts  from  production 

I 

$696,756,926.01 

Producing  costs,  including  maintenance 

517,083,955.02 

Administrative  and  selling  costs 

18,551,552.75 

535,635,507.77 

Net  receipts  from  operations 

161,121418.24 

Other  income 

9,159,863.74 

Gross  income 

170,281,281.98 

Taxes 

4,356,126.36 

Interest 

29401,328.68 

33,757455-04 

Net  income  from  operations 

136,523,826.94 

Less  profits  between  departments,  not  yet  realized  by 

the  combined  business 

2,739403.74 
133,784423.20 

Appropriations   for   sinking  fu 

nds,  extraordinary  de- 

preciation  allowance,  etc., 

35,655,836.26 

Available  for  dividends 

98,128,586.94 

Dividends 

35,385,727.00 

Surplus  for  the  year 

62,742,859.94 

92  ACCOUNTS 

It  is  to  be  noted  that  all  items  appearing  on  the  balance  sheet  are 
either  property  (or  claims)  of  the  corporation  or  liabilities  incurred 
by  it  in  acquiring  that  property.  The  items  on  the  income  sheet,  on 
the  other  hand,  represent  no  property :  they  all  once  involved  pro- 
perty, but  that  property  has  now  ceased  to  be  identified  with  income 
or  costs,  and  is  registered  among  the  assets  or  the  liabilities;  the 
income  sheet  shows  whence  property  came  or  whither  it  went.  In 
very  few  cases,  of  course,  do  items  on  the  income  sheet  represent 
accounts  of  the  same  name ;  for  usually  so  many  cost  accounts  are 
kept,  for  purposes  of  detailed  study,  that  combinations  must  be  used 
to  show  general  conditions.  Even  condensed  balance  sheets,  like  that 
presented  above,  are  usually  made  up  of  detailed  accounts  combined 
to  show  things  in  the  large. 

It  is  often  convenient,  in  order  to  show  the  exact  relative  condi- 
tion of  all  matters  pertaining  to  income,  to  give  separately  five 
condensed  statements  —  supplements  to  the  general  income  sheet. 

The  first  two  show  the  elements  of  principal  income;  the  third 
shows  the  make-up  of  total  income;  the  next  shows  the  disposi- 
tion of  income;  and  the  last  shows  the  condition  of  the  surplus. 
They  are  illustrated  below. 

INCOME  STATEMENT 

Merchandise  Account 
Inventory,  Jan.  i,  1915        $  40,000        Sales  $187,000 

Purchases  150,000        Inventory,  Dec.  31,  191 5        30,000 

Gross  profit,  to  Trading 
Account  27,000 


$217,000 

$217,000 

Trading  Account 

Rent 

$  3,000 

Merchandise,  gross  profit     $27,000 

Wages 

10,000 

Conamissions  earned                 3,000 

Insurance 

300 

Depreciation 

1,000 

Advertising 

2,000 

Losses  from  bad  debts 

1,500 

General  expenses 

2,700 

Net  trading  profit  to  In- 

come Account 

9,500 
$30,000 

$30,000 

DISTINCTION   BETWEEN   CAPITAL  AND  REVENUE      93 

Income  Account 

Taxes  on  investments             $      100        Trading  profits  $  9,500 

Net  income,  to  Disposition                         Miscellaneous  profits  500 

of  Income  Account                11,900        Interest  on  investments  2,000 

$12,000  $12,000 


Disposition  of  Income 
Profit-sharing  distribution        $1,900        Net  income  $11,900 

Dividends  8,000 

Balance,  to  Surplus  2,000 

$11,900  $11,900 


Surplus  Account 

Loss  by  fire,  not  chargeable                       Balance,  Jan.  i,  191 5 

to  the  year                           $  3,000        Surplus  for  year 
Balance                                     17,000        Gain  on  bonds  sold 

$17,000 
2,000 
1,000 

$20,000  $20,000 


Balance  $17,000 

It  is  convenient  actually  to  have  on  the  books  a  Trading  Ac- 
count, an  Income  Account,  and  a  Disposition-of-Income  Account, 
and  to  close  to  them,  rather  than  to  general  Profit  and  Loss,  the 
other  accounts  related  to  them  as  above  shown,  and  finally  to  close 
these  accounts  themselves.  Then  the  statements  are  preserved 
on  the  books,  and  comparisons  between  years  are  easy. 

Many  persons  not  familiar  with  ledger  accounts  are  puzzled  by 
the  debit  and  credit  arrangement  and  prefer  an  ordinary  addition- 
and-sub traction  form.  That  form  is  shown  below  for  the  items 
given  above. 


94 

ACCOUNTS 

Income  Sheet 

Sales 

$187,000 

Inventory,  Jan.  i,  191 5 

$  40,000 

Purchases 

150,000 

Cost  of  goods  handled 

$190,000 

Inventory,  Dec.  31,  191 5 

30,000 

Cost  of  goods  sold 

160,000 

Gross  merchandise  profit 

$27,000 

Commission 

3,000 

Gross  trading  profit 

$30,000 

Rent 

3,000 

Wages 

10,000 

Insurance 

300 

Depreciation 

1,000 

Advertising 

2,000 

Losses  from  bad  debts 

1,500 

General  expenses 

2,700 

Expenses 

20,500 

Net  trading  profit 

$9,500 

Miscellaneous  profits 

500 

Interest  on  investment 

2,000 

Taxes  on  investment 

100 

1,900 

Net  income 

$11,900 

Profit  sharing  distribution 

1,900 

Dividends 

8,000 

9,900 

Surplus  for  the  year 

$2,000 

Surplus  Jan.  i,  191 5 

17,000 

$19,000 

Loss  by  fire,  not  chargeable 

to  the  year 

3,000 

Gain  on  bonds  sold 

1,000 

2,000 

Surplus  Jan.  i,  19 16 


$17,000 


CHAPTER  EIGHT 

THE    GENERAL    PRINCIPLES   OF   DEPRECIATION 

The  last  illustration  in  the  preceding  chapter  showed  that  in  treat- 
ing depreciation  one  is  concerned  not  chiefly  with  a  choice  between 
different  accounts  when  an  entry  is  originally  made,  but  with  the 
length  of  time  the  value  shall  remain  charged  to  capital  account. 
Allowing  for  depreciation  is  usually  called,  in  technical  terms, 
"writing  off."  The  expression  means  simply  that  the  valuation 
formerly  on  the  books  is  displaced  by  a  new  and  smaller  valuation. 
This  expression  is  used  whether  the  change  is  made  by  simply  re- 
valuing the  original  account  by  the  method  shown  in  Chapter  V, 
page  49,  or  through  a  depreciation  account,  as  shown  in  Appendix 
B,  II. 

The  converse  of  "writing  off"  is  "writing  up."  This  expression 
means  simply  that  the  valuation  set  upon  the  property  has  been  in- 
creased and  is  carried  forward  as  a  new  valuation.  It  is  hardly  likely 
to  be  done  through  the  medium  of  another  account,  unless  one  wishes 
to  open  an  account  called  "Appreciation,"  and  it  is,  therefore,  man- 
aged simply  by  bringing  down  a  new  valuation,  as  shown  in  Chap- 
ter V. 

We  have  already  considered  the  principle  of  depreciation  as  shown 
in  its  simplest  type,  and  we  must  now  see  some  of  the  particular 
forms  in  which  it  may  appear.  The  method  of  handling  it  will  de- 
pend upon  the  circumstances  under  which  it  occurs.  There  are  three 
main  policies  of  treating  depreciation,  and  one  or  more  of  these  three 
is  adapted  to  every  conceivable  case.  The  three  policies  are  these : 
first,  allowing  the  property  to  wear  out  or  go  to  decay  without  re- 
placement, on  the  theory  that  no  use  will  ever  again  be  had  for  its 
like;  second,  keeping  the  property  up  to  the  original  standard  by 
frequent  repairs  and  replacements  but  without  special  provision  for 
future  replacements;  third,  allowing  depreciation  to  continue  to  a 
certain  point  and  accumulating,  in  the  mean  time,  special  funds 
to  be  available  for  replaceijient  at  whatever  time  it  shall  become 


96  ACCOUNTS 

necessary.  Let  us  see  how  these  three  forms  will  appear  in  account- 
ing. 

The  first,  allowing  the  property  to  wear  out  without  provision  for 
replacement,  can  be  good  business  poUcy  under  only  one  condition, 
namely,  if  the  business,  or  that  department  of  it,  is  to  be  abandoned. 
In  such  a  case  poUcy  requires  full  benefit  to  be  got  from  the  plant 
without  large  cost  for  renewal  and  repairs.  The  property  must  be 
exhausted  as  thoroughly  as  possible.  An  easy  method  of  treating 
depreciation  under  such  a  condition  would  be  to  distribute  to  stock- 
holders all  net  receipts.  If  that  is  done,  stockholders  get  all  they 
are  entitled  to,  and  when  the  business  is  exhausted  the  profits  stop 
and  the  capital  is  gone.  If  the  capital  was  originally  wisely  invested 
and  has  been  properly  employed,  the  stockholders  will  ultimately 
receive  back  their  original  investment  in  the  final  winding-up  of 
affairs ;  for  if  the  business  could  have  replaced  the  worn-out  plant  — 
as  it  could  if  prosperous  —  it  can  pay  the  stockholders  as  much  as  re- 
placement would  have  cost,  which  is,  of  course,  practically  the  origi- 
nal capital.^  The  thing  works  automatically;  but  since,  as  a  matter 
of  fact,  the  stockholders  are  getting  their  capital  handed  back  to 
them  piecemeal,  they  must  be  informed  that  the  dividend  is  not  all 
profit,  or  they  may  be  sadly  deceived  and  led  to  consequent  extrava- 
gance and  ultimate  loss.  Careful  accounting  should  show  that  a 
part  of  each  dividend  of  this  sort  is  not  earnings,  but  is  simply  capi- 
tal returned  because  the  business  has  no  further  use  for  it.  The 
common  type  of  this  sort  of  thing  is  found  in  mining  and  quarry- 
ing. Properties  like  ore  beds,  which  are  exhausted  in  the  process 
of  earning  profits  and  cannot  be  replaced  by  maintenance,  are  com- 
monly called  ''wasting  assets." 

It  will  pay  to  examine  at  this  point,  for  the  principle  is  funda- 
mental, the  origin  of  the  property  paid  to  stockholders  as  return  of 
their  capital.  The  original  assets  are  converted,  by  the  processes 
of  business,  into  other  types  of  assets,  and  either  these  later  assets 
may  be  reconverted  into  the  original  type,  providing  repairs  and 

^  Of  course  fluctuations  may  occur  in  costs  between  the  time  of  original  investment 
and  the  time  of  exhaustion,  and  in  any  particular  case  the  capital  may  not  be  restored; 
but  the  price  of  commodities  cannot  ordinarily  and  permanently  fall  so  low  as  to  fail 
to  supply  replacement  funds  for  goods  manufactured  under  proper  conditions;  or  else 
manufacturing  would  not  pay. 


THE  GENERAL  PRINCIPLES  OF  DEPRECIATION         97 

replacement,  or,  as  in  the  case  of  wasting  assets,  the  particular 
business  activity  must  cease.  We  may  go  so  far  as  to  say  that  the 
original  assets,  machinery  or  ore-beds,  for  example,  have  become, 
through  the  processes  of  wearing  out  or  excavation,  textiles  or 
metal,  perhaps,  then  debts  of  customers,  then  cash.  At  this  stage 
of  the  process,  the  Hst  of  assets  will  show  less  machinery  or  ore, 
and  more  cash.  The  books  of  account,  if  they  are  to  tell  the  truth, 
must  register  this  change.  The  thing  to  note  here  is  that  the  pre- 
servation of  the  original  investment,  if  to  be  provided  at  all,  must 
come  out  of  the  product  of  the  business.  There  are  no  profits  at  all 
if  the  product  is  not  sufficient  to  pay  all  running  expenses  and  still 
leave  free  assets  equal  in  value  to  the  original  capital  that  has  been 
consumed.  If,  then,  on  our  income  sheet,  we  treat  the  destruction 
of  original  capital  as  a  cost  of  business,  and  on  our  balance  sheet 
deduct  that  destruction  from  the  previous  value  of  our  machinery 
or  ore-beds,  we  shall  have  what  is  desired  on  our  statements.  The 
obvious  entry  is  to  debit  Profit  and  Loss  (or  Depreciation,  a  sub- 
division) and  credit  Machinery,  or  Ore-beds.  The  property  that 
now  takes  the  place  of  the  machinery,  or  ore-beds,  is  not  recog- 
nizable on  the  balance  sheet,  of  course,  as  a  substitute  for  the  ex- 
hausted original  property,  —  at  least  from  any  entry  which  we 
have  yet  made:  it  looks  just  like  any  other  assets.  The  cash  that 
came  as  return  from  the  labor  of  workmen  is  just  like  the  cash  that 
came  from  the  exhaustion  of  property.  Only  our  nominal,  or  ex- 
planation, accounts  can  tell  us  how  much  of  our  assets  owes  its 
origin  to  labor  and  how  much  to  exhaustion  of  property.  In  other 
words,  if  we  wish  to  know  where  is  the  property  that  takes  the  place 
of  the  exhausted  original  property,  our  answer  is  that  it  is  scattered 
through  our  general  assets  —  into  which  the  original  property  has 
been  in  part  converted.  Of  course,  then,  so  much  of  the  general 
assets  are  available,  if  we  care  to  use  them,  for  returning  to  stock- 
holders that  part  of  their  original  capital  for  which  there  is  no 
further  use. 

This  may  be  done  by  (Plan  I)  reducing  stock,  by  (Plan  II)  buy- 
ing stock  in  the  market  (if  allowable  by  law),  or  by  (Plan  III)  ac- 
cumulating a  fund  for  ultimate  redemption.  Under  the  first  of 
these  plans,  no  new  account  will  appear  on  the  balance  sheet;  ulti- 
mately assets  and  liabilities  will  go  down  together.   If  we  assume 


98  ACCOUNTS 

that  we  started  with  Plant  at  $90,000  and  Capital  Stock  at  $100,- 
000,  we  should  have  during  the  process  of  business  a  shrinkage  of 
Plant  to  possibly  $80,000,  with  an  increase  of  other  assets  by  $10,- 
000,  and  then  a  loss  of  the  $10,000  of  other  assets  and  a  shrinkage  of 
Capital  Stock  to  $90,000  —  giving  finally  the  figures  shown  in  the 
table  below.  The  second  plan  would  be  similar  except  that  Treas- 
ury Stock  as  an  asset  would  be  substituted  for  a  reduction  of  Capi- 
tal Stock  as  a  liability,  —  which  is  the  same  as  saying  that  the  only 
change  from  the  original  condition  is  a  substitution  of  Treasury 
Stock  for  $10,000  of  Plant.  Under  the  third  plan,  the  $10,000  would 
be  placed  in  a  separate  cash  fund,  and  hence  would  be  created  out 
of  the  general  assets  into  which  the  original  investment  had  been 
converted.  These  are  shown  in  tabular  form  below. 

Balance  Sheets 
Assets  Liabilities 

First  year  —  All  plans 
Plant  90,000         Capital  Stock  100,000 

Second  year  —  Plan  I 
Plant  80,000         Capital  Stock  90,000 

Second  year  —  Plan  II 
Plant  80,000         Capital  Stock  100,000 

Treasury  Stock  10,000 

Second  year  —  Plan  III 
Plant  80,000         Capital  Stock  100,000 

Retirement  Fund  10,000 

Income  Sheet 
All  plans 
Depreciation  (included  in  operating  expenses,  or,  better,  given  sepa- 
rately as  an  element  in  such  expenses)  10,000 

Now  we  are  ready  for  our  second  sort  of  policy  in  the  treatment 
of  depreciation.  In  this,  replacements  and  repairs  are  made  as  they 
may  become  necessary  to  maintain  the  original  standard,  and  no 
effort  is  made  to  provide  funds  for  future  replacements  or  repairs. 
This  used  to  be  the  policy  of  railroads.  Railroad  property  comprises 
so  many  parts  —  depreciating  at  so  many  varying  rates,  and  most 
of  the  parts,  such  as  cars,  rails,  ties,  bridges,  etc.,  lending  themselves 
readily  to  exact  repairs  or  complete  replacement — that  the  neces- 


THE  GENERAL  PRINCIPLES  OF  DEPRECIATION         99 

sary  repairs  or  replacements  in  any  one  year  are  likely  to  measure 
fairly  well  the  average  rate  for  all  years.  It  is  obvious  that  under 
such  circumstances,  with  intelligent  and  careful  daily  bookkeeping, 
depreciation  to  great  extent  takes  care  of  itself.  The  property  ought 
to  be  in  as  good  condition  at  the  end  of  the  year  as  at  the  beginning; 
and,  if  it  is  so,  a  debit  to  revenue  of  the  cost  of  repairs  and  replace- 
ments is  all  that  is  necessary  to  make  the  books  tell  the  truth.  Obvi- 
ously this  treatment  of  depreciation  cannot  appear  on  the  balance 
sheet.  The  balance  sheet  does  not  represent  the  transactions  of 
the  year  except  as  those  transactions  produce  results  that  last  into 
the  new  year  and  affect  resources  and  liabilities.  Repairs  and 
replacements,  since  they  have  simply  maintained  the  old  status, 
cannot  show  on  the  balance  sheet.  On  the  income  sheet,  however, 
they  must  be  included  among  the  costs  or  expenses  of  conducting 
the  business. 

Under  the  third  policy  of  treating  depreciation,  repairs  are  pre- 
sumed to  be  unable  to  maintain  the  property  at  its  original  standard. 
For  example,  many  buildings  used  for  manufacturing  purposes 
depreciate  rapidly  under  the  influence  of  steam,  jar,  and  chemicals, 
and  cannot  be  maintained  by  economical  repairs.  A  manufacturing 
corporation  having  such  buildings,  since  it  cannot  keep  them  re- 
newed by  ordinary  or  even  extraordinary  repairs,  must  naturally 
replace  them.  It  may  chance  that  two  buildings  may  need  to  be 
replaced  in  one  year  and  that  for  five  following  years  no  other  may 
need  attention.  Clearly,  that  one  year  should  not  sufifer  a  charge 
to  revenue  of  the  cost  of  the  two  new  buildings  and  leave  five  years 
to  escape  without  any  such  loss.  Bookkeeping  of  that  sort  would  be 
almost  as  deceptive  as  would  charging  the  new  buildings  to  Real 
Estate.  There  was  as  much  depreciation  in  each  of  the  six  years  as 
in  the  one.  The  proper  method  is  to  charge  depreciation  each  year 
with  a  fair  proportion  of  the  wear  and  tear  that  is  not  offset  by 
repairs,  and  to  lay  aside  or  retain  in  the  business  from  each  year's 
income  an  equivalent  sum  as  a  depreciation  fund.  This  fund  must 
be  available  whenever  replacement  becomes  necessary. 

This  policy  will  show,  or  have  effect,  upon  both  the  income  sheet 
and  the  balance  sheet.  The  depreciation  would  appear  on  the  in- 
come sheet  as  among  the  losses  or  expenses.  On  the  balance  sheet, 
it  may  appear  in  either  of  two  ways,  or  not  at  all.  If  (Plan  I)  the  fund 


lOO  ACCOUNTS 

is  set  aside  in  property,  Real  Estate  and  Plant  would  have  been 
written  off,  and  among  the  other  resources  would  appear  an  item 
of  Depreciation  Fund  for  the  amount  of  money  set  aside.  In  prin- 
ciple, this  case  is  similar  to  that  discussed  above,  on  page  97;  the 
difference  hes  in  the  fact  that  this  stops  a  little  short  of  that.  The 
assets  derived,  by  natural  process,  from  wearing  out  the  fixed  prop- 
erty —  machinery,  for  example  —  are  not  returned  to  the  stock- 
holders as  unnecessary  for  business  purposes,  but  are  held  await- 
ing the  time  when  they  shall  be  reconverted  into  machinery.  Lest 
they  may  not  be  sufficiently  available  for  immediate  use  when 
needed  —  sufficiently  liquid  —  they  are  put  into  a  special  fund, 
perhaps  invested  in  readily  saleable  bonds,  and  carried  on  the 
books  under  a  special  name.  (See  the  table,  page  102.) 

If,  on  the  other  hand,  the  assets  realized  from  the  conversion  of 
machinery,  by  wear  and  tear,  into  finished  goods  are  not  set  apart 
or  invested  in  a  distinct  fund,  but  are  utilized  (Plan  II)  in  the  busi- 
ness (sometimes  the  most  profitable  use  to  make  of  such  assets), 
they  are  not  recognizable  on  the  books  or  on  the  balance  sheet  as 
having  such  origin  or  constituting  a  depreciation  fund.  Sometimes 
doubt  arises  in  the  minds  of  the  uninitiated  as  to  the  reality  of  a 
depreciation  fund  that  does  not  appear  on  the  books  under  that 
title.  The  matter  is  plain  only  when  one  sees  the  origin  of  such  a 
fund.  As  a  matter  of  fact,  the  case  is  exactly  similar  to  those  al- 
ready discussed.  Instead  of  real  estate  and  plant,  the  business  has 
cash  or  claims  arising  from  the  sale  of  goods  produced  by  the  wear 
and  tear  of  real  estate  and  plant.  If  on  the  books  and  on  the  income 
sheet  the  actual  depreciation  is  treated  as  a  cost,  and  is  also  de- 
ducted from  the  value  of  the  property  on  the  books  and  on  the 
balance  sheet,  a  part  of  the  assets  must  be  those  into  which  the 
depreciating  property  has  converted  itself.  We  may  see  this  by 
observing  what  are  the  sources  of  assets. 

An  increase  in  the  total  amount  of  assets  can  come  from  only 
three  sources  —  new  investment  by  proprietors  or  stockholders, 
loans  (or  credit  transactions)  by  outsiders,  and  profits;  but  an  in- 
crease in  any  particular  asset  may  come  from  the  exchange  of  any 
other  asset.  When  any  one  of  the  three  sources  just  mentioned  as 
available  for  an  increase  in  the  total  amount  of  assets  is  resorted 
to,  double  entry  requires  an  explanation  that  will  appear  on  the 


THE    GENERAL   PRE^CIPLES   OF    DEPRECIATION       lOI 

credit  side  of  the  balance  sheet;  for  new  investment  will  appear  as 
capital,  loans  as  bonds  or  notes  or  accounts  payable,  and  profits  as 
surplus.  If,  then,  the  total  assets  equal  the  total  liabilities  —  in 
other  words,  if  the  balance  sheet  balances  —  any  new  assets  de- 
rived from  new  investment,  loans,  or  profits  have  been  accounted 
for,  and  the  remaining  assets  must  be  enough  to  cover  all  the  old 
liabilities  (investment,  borrowings,  profits),  for  the  old  Habilities 
are  still  on  the  balance  sheet  (which  balances) ;  so  assets  to  offset 
depreciation  are  on  hand  somewhere,  but  undesignated,  among  the 
other  assets;  for  depreciation  has  not  been  allowed  to  reduce  the  lia- 
bility of  the  business  to  any  one.  To  summarize,  if  the  depreciation 
is  counted  as  a  cost,  so  that  profits  are  not  overstated,  and  if  the 
property  is  correspondingly  written  down  on  the  balance  sheet  (and 
no  property  is  overvalued),  a  balance  sheet  that  shows  no  deficit 
must  have  among  its  assets  enough  to  replenish  the  depreciated 
property;  for,  since  assets  equal  liabilities,  all  original  capital  and 
loans,  plus  all  later  capital  and  loans,  plus  all  accumulated  profits, 
are  matched  by  assets,  and  so  any  exhaustion  of  original  capital 
locked  up  in  plant  must  be  offset  by  other  assets  —  obtained  in  the 
processes  of  business  in  exchange  for  the  original  plant.  If  there  are 
not  enough  available  assets  to  provide  for  replacement  of  the  prop- 
erty, depreciation  was  not  the  cause:  the  fact  must  be  that  the 
manager  has  allowed  too  many  assets  to  attain  an  unliquid  state,  — 
either  the  assets  which  should  have  been  kept  liquid  have  been  tied 
up,  or  else  the  business  needs  more  capital  and  has  been  borrowing, 
so  to  speak,  from  its  replacement  assets  to  provide  assets  needed 
in  less  liquid  form. 

Sometimes  the  same  situation  is  represented  in  the  accounts  far 
otherwise.  Some  business  houses  object  to  writing  down  their 
assets,  because  they  think  those  unacquainted  with  accounts  will 
assume  that  they  are  running  down  hill.  Instead  of  crediting  asset 
accounts,  therefore,  with  a  debit  to  Profit  and  Loss  for  depreciation, 
they  debit  Profit  and  Loss  and  credit  Depreciation,  or  Reserve  for 
Depreciation  (Plan  III).  Then  the  assets  stand  at  their  original  fig- 
ures, as  if  worth  as  much  as  ever.  In  other  words,  these  houses  re- 
port an  exaggerated  valuation  of  assets,  but  offset  this  by  an  exag- 
geration of  liabilities  —  the  new  liabiUty  being  no  liability  at  all, 
but  merely  a  necessary  deduction  from  assets.  This  is  the  extreme 


I02  ACCOUNTS 

application  of  the  principle  that  in  bookkeeping  deductions  are 
made  not  by  subtractions  but  by  additions  on  the  contrary  side. 
Though  the  principle  may  apply  to  books,  it  should  not  apply  to 
statements  published  for  the  use  of  the  uninitiated  pubHc.  If  the 
practice  were  not  common  and  of  long  standing,  one  could  call  it 
reprehensible.  It  is  at  best  unfortunate.  In  view  of  the  other  uses 
for  the  word  "  Reserve,"  to  be  discussed  later,  the  title  used  should 
indicate  clearly  that  the  credit  item  is  a  mere  deduction  from  as- 
sets, as  ^'Allowance  for  Depreciation."  Usually  the  preferable 
plan  is  to  reduce  the  assets. 

Balance  Sheets 
Assets  Liabilities 

First  year  —  All  plans 
Plant  90,000 

Second  year  —  Plan  I 
Plant  80,000 

Depreciation  Fund  10,000 

Second  year  —  Plan  II 
Plant  80,000 

[Miscellaneous  assets  in- 
creased] 10,000 

Second  year  —  Plan  III 
Plant  90,000    Allowance  for  Depreciation    10,000 

[Miscellaneous  assets  in- 
creased] 10,000 

Income  Sheet 
All  plans 
Depreciation  (included  in  operating  expenses,  or,  better,  given  sepa- 
rately as  an  element  in  such  expenses)  10,000 

So  far  we  have  noted  only  pure  conditions  —  exhausting  the 
property  or  keeping  it  up.  The  common  condition  is  mixed  — 
keeping  up  part  and  allowing  part  to  run  down.  We  must  note 
first  that  keeping  up  property  does  not  mean  keeping  up  each  bit 
of  property.  An  absolutely  new  bit  of  property  cannot  be  kept  up; 
but  after  a  certain  age  most  kinds  of  property  may  be  kept  up  to 
that  aged  standard  by  replacement  of  some  parts  new  each  year, 
improving  upon  the  standard,  while  other  parts  are  suffered  to  de- 


THE    GENERAL   PRINCIPLES   OF   DEPRECIATION      IO3 

cline  —  thus  maintaining  the  standard  '  as  a  whole.  So  a  single 
new  building  cannot  be  absolutely  maintained  in  value,  though  a 
single  old  building  virtually  may  be;  but  a  sufficiently  large  group 
even  of  new  buildings  may  be  maintained  in  value,  for  each  year 
enough  new  buildings  may  be  added  to  keep  up  the  value  of  the 
group,  even  though  those  previously  new  have  suffered  deprecia- 
tion. Technically,  expenditure  to  keep  property  up  to  standard  is 
called  ''maintenance,"  and  suffering  it  to  decline  involves  "depre- 
ciation." In  practical  accounting,  the  standard  is  the  standard  of 
the  last  earning  period,  whatever  that  period  may  be;  for  if  the 
property  is  as  good  as  it  was  the  last  time  the  books  were  closed,  no 
allowance  for  depreciation  as  cost  becomes  necessary  for  the  new 
period. 

Obviously,  if  the  property  is  partly  maintained  and  partly  de- 
preciated, the  books  and  statements  should  show  a  combination  of 
two  at  least  of  the  policies  just  discussed.  Let  us  suppose  the  busi- 
ness is  to  continue,  and  that  it  would  take  $7,000  a  year  to  main- 
tain the  plant  in  condition,  but  that  for  three  years  the  actual  ex- 
penditures are  as  follows:  $3,000,  $4,000,  $5,000;  and  that  in  the 
first  year  a  depreciation  fund  was  set  aside,  but  not  increased  later, 
and  in  the  third  year  Plant  was  not  written  down.  Then  the  in- 
come sheets  should  show  as  costs  the  following: 


First  year 

Second  year 

Third  year 

Maintenance 

$3,000 

$4,000 

$5-000 

Depreciation 

4,000 

3,000 

2,000 

Let  us  suppose  we  have  the  condensed  balance  sheet  at  the  begin- 
ning of  the  first  year,  as  indicated  below. 

Balance  Sheet  at  Beginning 

Plant                              $100,000        Capital  Stock  $150,000 

Other  assets                     100,000        Outside  liabilities  50,000 

$200,000  $200,000 

If  all  profits  are  distributed  as  dividends,  we  shall  have  subsequent 
balance  sheets  as  shown. 

One  year  later 
Plant  $96,000        Capital  Stock  $150.0^0 

Depreciation  Fund  4,000        Outside  liabilities  50,000 

Other  assets  100,000 

$200,000  $200,C^0 


104  ACCOUNTS 


Two  years  later 

Plant 

Depreciation 
Other  assets 

Fund 

$  93,000        Capital  Stock  ^ 
4,000        Outside  liabilities 
103,000 

$150,000 
50,000 

$200,000 

$200,000 

Three  years  later 

Plant 

Depreciation  Fund 
Other  assets 

$  93,000        Capital  Stock 
4,000        Outside  liabilities 
105,000        Allowance  for  Depreciation 

$150,000 

50,000 

2,000 

$202,000  $202,000 

If  we  assume  that  the  property  is  now  to  be  carried  to  its  original 
standard,  we  find  that  $9000  must  be  spent  —  the  sum  of  the  three 
depreciations  of  the  income  sheets,  and  also  the  Allowance  for  De- 
preciation plus  the  difference  between  the  last  figure  for  Plant  and 
the  first;  but  we  also  find  property  for  the  purpose.  The  Deprecia- 
tion Fund  amounts  to  $4000  (waiving  for  the  moment  interest  pre- 
sumably earned  by  it),  and  the  other  assets  have  a  free  excess,  over 
the  original  other  assets,  of  $5000.  Debiting  Plant  for  the  improve- 
ments gives  Plant  $102,000;  but  the  Allowance  for  Depreciation 
must  be  set  off  against  this,  or  transferred  to  this  account,  leaving 
our  original  $100,000. 

We  should  note  that  expenditure  to  restore  property  once  written 
down  is  charged  to  the  property,  to  restore  it  on  the  books;  but 
expenditure  to  maintain  property  not  written  down  is  charged  to 
maintenance,  as  a  cost  on  the  income  sheet,  —  otherwise  the  prop- 
erty would  be  overvalued. 

We  have  so  far  discussed  depreciation  and  maintenance  as  if 
property  were  never  given  better  treatment  than  maintenance. 
Sometimes  a  repair  or  replacement  not  only  restores  value  as  it  was 
at  the  beginning  of  the  period,  but  actually  extends  the  Hfe  of  the 
property;  and  sometimes  this  occurs  not  only  for  one  piece  of  prop- 
erty, offsetting  loss  of  value  on  other  pieces  of  property,  but  for  so 
many  pieces  that  the  value  as  a  whole  is  increased.  Obviously  in 
such  a  case  a  part  of  the  expenditure,  that  which  is  in  excess  of  the 
amount  needed  for  maintenance,  should  be  charged  to  the  property 
account,  increasing  it  on  the  balance  sheet.  The  difficulty  is  to 
know  from  time  to  time,  as  entries  are  made,  when  maintenance 
ends  and  improvement  begins.   Not  until  one  sees  things  in  the 


THE   GENERAL   PRINCIPLES    OF   DEPRECIATION      105 

large  can  one  distinguish,  and  one  cannot  usually  see  them  in  the 
large  as  they  occur.  It  is  desirable,  moreover,  to  charge  deprecia- 
tion and  maintenance  month  by  month  and  not  wait  until  the  end 
of  the  quarter,  half-year,  or  year.  So  far  as  costs  are  concerned, 
there  is  no  difference  between  maintenance  and  depreciation.  Both 
are  costs  of  doing  business.  The  only  difference  between  them  is 
that  in  the  case  of  maintenance  cash  is  exhausted  in  the  process  of 
making  repairs  and  replacements  which  are  necessitated  by  the 
destruction  of  property  used  in  producing  or  selling  goods,  but  in 
the  case  of  depreciation  machinery  or  other  property  is  exhausted 
directly  in  producing  or  selling  goods.  The  cost  lies  in  the  exhaus- 
tion of  property,  whether  exhaustion  of  cash  to  replace  other  prop- 
erty or  exhaustion  of  other  property  directly.  When,  then,  the  cost 
of  complete  maintenance  is  estimated  from  watchful  experience, 
it  is  possible  to  charge  as  an  expense  this  amount  monthly,  or  one- 
twelfth  the  annual  estimate,  whether  the  expenditure  is  actually 
made  for  maintenance  or  not.  Then  at  the  end  of  the  year  the 
actual  expenditure  for  maintenance  is  compared  with  the  estimate 
and  the  difference,  if  any,  accounted  for.  If  the  actual  maintenance 
is  less  than  the  estimate  used,  and  if  the  experience  of  the  year  sup- 
ports the  estimate  of  what  would  have  been  required  to  keep  the 
property  up  to  standard.  Depreciation  will  be  charged  for  the 
difference  and  the  property  will  be  credited  for  the  shrinkage.  If 
the  amount  spent  is  in  excess  of  the  estimate,  and  the  experience 
supports  the  estimate,  obviously  the  charge  made  as  an  expense 
should  be  corrected  by  a  debit  to  the  property  account  and  a  credit 
to  the  account  originally  charged. 

The  bookkeeping  entries  are  interesting.  The  account  for  origi- 
nal estimated  monthly  charges  may  well  be  called  Temporary  De- 
preciation, and  when  it  is  debited  Allowance  for  Depreciation  may 
be  credited.  The  actual  expenditures  for  maintenance  may  be 
charged  to  Maintenance,  as  usual.  Let  us  suppose  that  the  esti- 
mate for  wear  and  tear  is  $6,000  a  year.  Then  at  the  end  of  each 
month  the  entry  will  read 

Temporary  Depreciation  $5CX) 

To  Allowance  for  Depreciation  $500 

If  the  actual  expenditure  is  $400  each  month,  the  entry  will  be 

Maintenance  $400 

To  Cash  $400 


I06  ACCOUNTS 

The  monthly  statements  of  profit  and  loss,  of  course,  will  treat 
Temporary  Depreciation  as  a  cost.  Maintenance,  on  the  other 
hand,  since  it  is  a  payment  of  the  liability  recorded  under  the  head 
of  Allowance  for  Depreciation,  is  an  asset:  as  the  exhaustion  of 
property  still  stands  as  a  Hability,  the  replenishment  must  stand  as 
an  asset. 

At  the  end  of  the  year  the  accounts  will  look  as  follows  (using 
totals  and  omitting  Cash) : 

Temporary  Depreciation 
$6,000 

Allowance  for  Depreciation 

$6,000 
Maintenance 
$4,800 

If  now  we  debit  Depreciation  (the  usual  nominal  account  —  see 
entry  below)  for  the  $1200  deficient  maintenance,  and  credit 
Temporary  Depreciation,  the  facts  regarding  both  maintenance  and 
depreciation  will  show  on  our  books;  for  Maintenance  will  show 
at  $4800  and  Depreciation  at  $1200.  We  shall  now  have  a  balance 
of  $4800  on  Temporary  Depreciation  and  of  $6000  on  Allowance 
for  Depreciation;  of  the  latter,  $1200  represents  actual  deduction 
to  be  made  from  the  property  account.  We  might  now  cancel  the 
Maintenance  against  the  Allowance  for  Depreciation  (the  replen- 
ishment account  against  the  exhaustion  account),  and  report  the 
Temporary  Depreciation  as  a  cost  on  the  income  sheet.  This  would 
make  a  misleading  statement,  however;  so  we  correct  the  $4800 
Temporary  Depreciation  and  the  $4800  of  the  Allowance  for  De- 
preciation (since  our  Maintenance  shows  that  to  that  extent  the 
depreciation  was  made  good)  and  report  the  Maintenance  (having 
a  balance  of  the  same  amount)  on  the  income  sheet  as  a  cost.  De- 
preciation (not  Temporary  Depreciation)  also  appears  here.  The 
correcting  entry  is  to  debit  Allowance  for  Depreciation  $4800  and 
credit  Temporary  Depreciation  $4800.  The  entries,  with  the  re- 
sulting ledger,  follow. 

Depreciation  1 200 

To  Temporary  Depreciation  1200 

Allowance  for  Depreciation  4800 

To  Temporary  Depreciation  4800 


THE   GENERAL   PRINCIPLES   OF   DEPRECIATION       10/ 

Temporary  DEPREaATiON 


6oco 
6000 

Allowance  for  Depreciation 

1200 

4800 
6000 

4800 

6000 

Maintenance 

4800 

Depreciation 

1200 


If,  on  the  other  hand,  our  actual  expenditure  for  repairs  and 
replacements  were  more  than  $6000,  instead  of  an  entry  to  De- 
preciation w^e  should  need  an  entry  to  the  property  account.  Our 
debit  to  Maintenance  would  show  that  Temporary  Depreciation 
and  Allowance  for  Depreciation  had  no  longer  any  validity,  and 
the  excess  of  this  debit  to  Maintenance  over  the  Allowance  for 
Depreciation  would  indicate  how  much  more  care  than  mere  main- 
tenance the  property  had  been  given.  Such  excess  should  be 
closed  to  the  property,  by  an  entry  debiting  the  property  account 
and  crediting  Maintenance.  Then  the  balance  of  Maintenance 
would  be  closed  to  Profit  and  Loss  as  an  expense  of  the  period 
and  reported  on  the  income  sheet.  Finally,  as  Temporary  Depre- 
ciation and  Allowance  for  Depreciation  are  wholly  met  by  the 
amount  of  Maintenance  just  closed  to  Profit  and  Loss,  they  should 
be  canceled,  one  against  the  other,  by  debiting  the  latter  $6000 
and  crediting  the  former  the  same  amount.  Then  we  have  a  clean 
score. 

The  Interstate  Commerce  Commission  requirements  for  the 
treatment  of  depreciation  by  railroads  (succeeding  the  former  pol- 
icy of  most  roads,  which  assumed  that  maintenance  kept  up  their 
property)  are  similar  to  the  treatment  described  above;  but  the 
titles  used  for  the  accounts  are  so  technical  as  to  require  more  ex- 
planation than  is  fitting  for  illustrations  here. 

Depreciation  of  merchandise  is  in  a  somewhat  different  category 
from  depreciation  of  fixed  property.  Since  merchandise  is  sup- 
posedly constantly  flowing,  a  progressive  depreciation  may  or  may 
not  be  necessary.  When  a  stock  of  goods  has  once  attained  an  age 


Io8  ACCOUNTS 

normal  for  its  line  of  business  and  has  been  depreciated  to  a  value 
recognizing  that  age,  further  depreciation  is  not  necessary  if  the 
stock  is  not  depleted  of  newer  goods  or  held  stagnant  enough  to 
increase  its  average  age.  The  replenishment  of  stock  is  then  exact- 
ly equivalent  to  maintaining  its  value,  and  depreciation  no  more 
occurs  with  it  than  with  any  large  property  that  is  kept  up  by  re- 
placing old  parts  and  repairing  new  ones  fast  enough  to  keep  the 
average  constant.  If,  on  the  other  hand,  some  parts  of  the  stock 
get  older  and  older  (assuming  the  usual  type  of  merchandise  with 
which  age  means  shrinkage  of  value)  and  there  is  no  ojffset  else- 
where, progressive  depreciation  must  be  applied. 

One  caution  has  been  found  often  necessary  in  this  connection. 
Managers  have  reported  that  they  have  depreciated  stock  5% 
every  six  months,  or  10%  a  year,  for  many  years.  They  have  con- 
sidered this  liberal.  On  analysis  the  fact  has  been  disclosed  that 
their  stock  was  depreciated  5%  once  and  once  only.  Inventories 
were  taken  always  at  purchase  price  and  then  depreciated.  Writ- 
ing off  5%  depreciation  from  purchase  prices  under  this  plan  may 
be  done  as  often  as  is  imaginable  and  still  never  amount  to  more 
than  5%;  for  at  each  period  of  figuring  profits  the  5%  taken  off 
at  the  last  period  was  put  back  (in  the  purchase-price  inventory) 
before  the  new  5%  was  taken.  The  only  way  to  get  a  progressive 
depreciation,  of  course,  is  to  take  each  percentage  of  depreciation 
off  the  last  depreciated  value  —  not  off  the  original  value. 


CHAPTER  NINE 

THE    GENERAL   CHARACTERISTICS   AND   THE    INTERPRETA- 
TION  OF   BALANCE    SHEETS 

Perhaps  the  best  way  to  apply  the  truths  discussed  in  the  last  two 
chapters  is  to  take  an  imaginary  balance  sheet  and  see  what  criticism 
can  be  apphed  to  it.  As  a  prehminary  to  this,  however,  it  is  desirable 
to  examine  in  detail  some  general  facts  about  the  most  common  items 
appearing  on  balance  sheets.  We  will  use,  for  a  basis,  a  comparison 
of  imaginary  balance  sheets  for  three  years.     (See  page  no.) 

It  was  suggested  in  Chapter  VII  that  the  name  by  which  an  ac- 
count is  called  is  of  far  less  importance  than  its  disposition  in  closing 
the  books  for  the  year,  —  that  is,  determining  whether  its  amount 
shall  go  into  the  income  sheet  or  into  the  balance  sheet,  shall  be 
charged  to  capital  or  to  revenue.  This  suggests  the  necessity  of 
getting  behind  the  returns  in  any  corporation  statement.  The  first 
items  on  a  manufacturing  balance  sheet  are  usually  Real  Estate  and 
Plant.  Though  ordinarily  they  should  be  separated,  they  may  here 
be  considered  together.  The  obvious  questions  in  connection  with 
them  are,  first,  what  is  the  basis  of  the  valuation,  and,  secondly, 
what  is  the  allowance  for  depreciation.  Of  the  valuation  usually 
no  judgment  can  be  formed  unless  one  can  examine  the  property 
itself.  On  the  second  question,  however,  means  can  often  be  found 
for  forming  some  judgment.  The  figures  of  the  balance  sheets  given 
below  indicate  that  in  the  year  1907  $20,000  was  allowed  for  de- 
preciation and  was  set  aside  as  a  special  fund  for  repairs  or  replace- 
ment ;  for,  on  comparing  the  sheets  for  the  two  years,  we  see  that  the 
Real  Estate  and  Plant  items  have  been  written  off  to  the  amount  of 
$20,000,  and  that  a  depreciation  fund  is  among  the  assets.  This  de- 
preciation fund  must  be  a  real  thing,  for  it  could  not  appear  among 
the  assets  under  the  name  of  a  fund  under  any  other  conditions  — 
unless,  indeed,  the  books  lie.  All  the  resource  accounts  except  a 
possible  profit  and  loss  deficit,  which  is  a  resource  only  as  it  explains 
or  satisfies  the  stockholders  as  to  what  has  become  of  their  property, 


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CHARACTERISTICS  OF  THE  BALANCE  SHEET         III 

must  be  real  accounts.  Hence  Depreciation  Fund  must  represent 
property  —  cash,  or  bonds,  or  something  of  that  sort  —  set  aside  to 
replace  the  worn-out  buildings  or  plant.  The  balance  sheet  ought  to 
state  what  the  property  is,  and  if  it  does  not  do  so  it  is  by  so  much 
deficient.  A  footnote  on  the  balance  sheet  stating  that  the  fund  is 
invested  in  certain  bonds  (giving  amounts,  valuation,  and  designa- 
tion of  bonds),  or  is  on  deposit  in  certain  banks,  or  is  invested  in 
certain  stocks  or  notes,  would  serve  the  purpose. 

In  this  case,  as  was  pointed  out  in  the  preceding  chapter,  the 
accumulation  of  this  depreciation  fund  has  cost  the  business  no 
sacrifice.  If  the  property  is  wearing  out  in  profitable  employment, 
it  is  reproducing  itself,  and  the  fund  is  that  reproduction  —  a  re- 
production of  value  in  another  form  ready  for  ultimate  conversion 
into  the  original  form.  The  fund  is  set  aside  not  out  of  profits,  but 
out  of  product;  for  there  can  be  no  profits,  or  excess  of  gains  over 
costs,  until  after  this  reproduction  has  been  provided  for;  and  it  is 
the  business  of  the  accountant  to  see  that  the  reproduction  is  rec- 
ognized and  recorded. 

This  fund,  however,  might  have  had  a  different  origin.  If  the 
property  had  not  been  worn  out,  or  if  it  had  been  maintained,  ob- 
viously such  a  fund  would  not  be  a  reproduction  of  the  property 
through  product.  Yet  so  far  as  the  product  is  in  excess  of  all  the 
costs,  including  any  depreciation  or  maintenance,  there  is  profit 
out  of  which  a  fund  may  have  been  set  aside.  Why  call  such  a  fund 
a  ** depreciation  fund"  if  no  depreciation  has  occurred?  The  legiti- 
mate use  of  such  a  fund  is  to  provide  a  reserve,  or  safety  fund,  as 
security  against  trouble  in  case  the  estimate  of  depreciation  is  in- 
adequate or  unexpected  shrinkages  in  value  occur  through  new  in- 
ventions, or  changes  of  fashion  or  custom,  which  render  old  property 
no  longer  so  serviceable  as  formerly.  It  is  an  extra  depreciation 
fund.  When  actual  loss  of  value  is  befieved  to  have  occurred,  the 
necessary  pro^'ision  for  depreciation  is  a  cost  and  must  come  out  of 
product  before  profit  can  be  determined;  but  if  adequate  provision 
for  depreciation  has  already  been  made  and  yet  the  managers  decide 
to  reserve  something  out  of  profits  (product  in  excess  of  costs)  for 
extraordinary  security,  rather  than  to  distribute  it  as  dividends, 
the  fund  is  as  truly  profits  as  if  it  had  been  distributed  as  di\adends 
under  the  same  conditions.  In  this  case,  as  in  those  cases  discussed 


112  ACCOUNTS 

in  the  preceding  chapter,  the  fund  as  specific  asset  may  appear  on 
the  balance  sheet  or  not.  If  the  fund  is  set  aside  as  distinct  prop- 
erty, withheld  from  what  otherwise  would  be  dividends,  it  should 
clearly  appear.  If  it  consists  merely  of  miscellaneous  assets,  — 
excess  of  assets,  from  profits,  over  Habilities  and  investment,  —  it 
could  not  appear  as  a  fund  but  its  existence  would  be  shown  by  the 
fact  that  the  assets  were  in  such  excess.  Whether  the  fund  as  an 
asset  is  set  aside,  and  therefore  shown,  or  not,  its  origin  must  be 
shown  on  the  credit  side.  Double  entry  requires  explanation  of 
everything,  and  since  a  credit  must  have  been  made  to  some  earn- 
ing account  when  the  property  (or  excess  assets)  was  realized,  the 
credit  must  still  be  on  the  books  (closed  from  the  earning  account 
to  Profit  and  Loss,  and  thence,  since  the  earnings  exceeded  the 
costs  and  dividends,  carried  to  some  sort  of  surplus  account).  The 
same  thing  may  be  explained  another  way:  assets  have  but  three 
sources  —  investment,  borrowing,  profits;  since  this  is  not  either 
of  the  first  two,  and  cannot  appear  as  such,  it  must  appear  as  the 
last.  We  shall  soon  examine  the  choice  of  titles  for  it. 

Unfortunately  such  a  condition  is  not  always  clearly  disclosed 
on  the  balance  sheet,  and  yet  the  matter  is  often  of  great  impor- 
tance. We  saw  in  the  preceding  chapter  that  sometimes  deprecia- 
tion is  recorded  on  books  of  account  and  on  balance  sheets  not  by 
writing  down  the  depreciated  property,  but  by  showing  an  account. 
Depreciation,  with  a  credit  balance  to  represent  the  amount  by 
which  the  real  value  of  property  is  overstated  in  the  property  ac- 
count, —  an  unsatisfactory  practice  because  it  is  an  indirect  way 
of  doing  an  obvious  thing.  When  one  sees  an  item  for  depreciation 
on  the  credit  side  of  a  balance  sheet  amoimting  perhaps  to  $50,- 
000,  how  is  one  to  know  whether  the  amount  is  the  measure  of 
the  depreciation  suffered  and  necessarily  to  be  subtracted  from  the 
value  of  property  shown  on  the  assets  side  of  the  sheet,  or  is  the 
measure  of  profits  (excess  of  earnings  over  costs)  withheld  from 
dividends  and  retained  as  a  safety  fund  for  miscalculations  or  emer- 
gencies? Uncertainty  in  this  regard  is  exactly  the  same  as  uncer- 
tainty as  to  whether  the  figure  is  $50,000  or  $00,000;  for  in  one 
case  the  amount  represents  surplus  profits  and  in  the  other  it  repre- 
sents no  profits  at  all.  As  a  matter  of  fact,  there  is  no  way  of  know- 
ing what  the  figure  means  unless  it  is  clearly  labeled,  and  no  uni- 


CHARACTERISTICS  OF  THE  BALANCE  SHEET    II 3 

formity  of  label  is  found  in  use.  Yet  clear  labels  can  be  found. 
Since  the  term  *'  fund  "  implies  an  asset,  it  is  desirable  to  confine  the 
use  of  that  word  to  special  property  set  aside  —  that  is,  the  assets 
side  of  the  balance  sheet.  The  item  to  represent  a  deduction  from 
assets  ought  to  suggest  its  purpose, and  for  this  the  term  ''allow- 
ance" is  convenient.  To  suggest  the  fact  that  profits  are  reserved, 
** reserve"  should  be  adequate.  Yet  accountants  use  these  terms 
with  varying  significance.  If  the  terms  were  used  as  suggested 
above,  the  various  combinations  of  items  appearing  on  balance 
sheets  would  be  interpreted  as  follows: 

Case  I 
Depreciation  Fund  $50,000        Allowance  for  Depreciation         $50,000 

Property  depreciated  and  overstated  on  the  assets  side,  but  a  special  fund 
set  aside  out  of  product  for  restoration. 

Case  II 
Depreciation  Fund  $50,000        Reserve  for  Depreciation  $50,000 

Property  maintained  (or  written  down  for  actual  depreciation),  and  an  extra 
safety  fund  set  aside  out  of  profits  ^dthheld  from  dividends. 

Case  III 
Depreciation  Fund  $50,000        Allowance  for  Depreciation  $20,000 

Reserve  for  Depreciation  30,000 

Property  depreciated  by  $20,000  and  overstated  in  value,  but  a  fund  of  $50,- 
000  set  aside,  of  which  $20,000  is  taken  from  product  as  a  cost,  and  $30,000  is 
retained,  for  extra  safety,  out  of  profits. 

Case  IV 
Allowance  for  Depreciation         $50,000 

Property  depreciated  and  overstated,  and  no  special  fund  set  aside  for  res- 
toration; but  the  fact  that  the  balance  sheet  balances  with  this  item  as  a  credit 
shows  that  the  assets  are  adequate  for  restoration  (provided  there  are  no  over- 
valuations). 

Case  V 
Reserve  for  Depreciation  $50,000 

The  property  has  been  maintained  (or  written  down  for  depreciation),  but 
out  of  profits  $50,000  has  been  withheld  from  dividends  as  an  extra  safety 
fund;  this,  however,  is  not  separately  set  aside  but  is  among  the  general  as* 
sets. 

Case  VI 
Depreciation  Fund  $50,000 

The  property  is  depreciated,  but  written  down,  and  assets  for  restoration 
are  set  aside. 


114  ACCOUNTS 

In  every  case  above,  the  assumption  is  that  the  books  are  prop- 
erly kept,  and  that  no  overvaluations  have  been  set  up  except  those 
indicated  by  the  Allowance  for  Depreciation;  but  of  course  there  is 
never  assurance  that  things  are  not  overvalued  unless  an  appraisal 
is  made.  One  is  not  justified,  moreover,  in  interpreting  figures 
on  balance  sheets  as  they  have  been  interpreted  above  unless  one 
knows  that  the  accountant  uses  his  terms  as  they  have  here  been 
used.  Many  accountants  habitually  use  the  term  "reserve"  for 
the  credit  item  to  indicate  a  deduction  from  assets  —  v/hat  above 
is  called  an  "allowance"  —  and  yet  use  it  occasionally  for  a  true 
reserve  from  profits.  Some  use  the  word  "fund"  only  on  the  credit 
side  for  profits  reserved  for  special  purposes.  In  view  of  this  am- 
biguity, it  would  be  well  if  on  all  balance  sheets  the  terms  were  ex- 
plained in  full,  as,  "Special  investments  for  restoration  of  depreci- 
ated property,"  "Allowance  for  depreciation,  to  be  deducted  from 
asset  valuations,"  and  "  Surplus  profits  reserved  to  meet  extraor- 
dinary depreciation."  Otherwise,  unless  one  knows  the  practice 
of  the  accountant  making  a  report  (or  knows  whether  the  prop- 
erty is  put  on  the  report  at  original  value  or  at  depreciated  value) 
one  cannot  interpret  a  credit  item  for  depreciation.  Investigation 
recently  disclosed  that  with  twenty  large  industrial  corporations 
showing  Reserve  for  Depreciation  the  item  in  ten  cases  meant  true 
profits  reserved  for  safety,  and  in  ten  cases  it  meant  a  simple  over- 
statement of  assets. 

The  principles  shown  here  are  equally  applicable  to  other  funds 
and  allowances.  Insurance  Fund,  for  example,  ought  to  represent 
special  assets  set  aside;  Allowance  for  Insurance  ought  to  be  an 
indication  that  at  least  in  part  the  business  is  self-insured  and  that 
the  risk  of  loss  distributed  over  a  period  of  time  has  accumulated 
to  the  amount  shown  —  a  measure  of  the  probability  of  shrinkage 
in  the  realizable  operating  value  of  the  property;  and  Reserve  for 
Insurance  should  be  the  measure  of  profits,  withheld  from  divi- 
dends, for  insurance  purposes  but  in  excess  of  any  believed  actual 
risk  of  loss  —  otherwise  the  amount  so  reserved  should  have  been 
reserved  out  of  product  as  a  cost,  and  hence  never  counted  as  profits 
available  to  be  reserved.  These  interpretations,  however,  like  the 
others,  are  on  the  assumption  that  the  terms  are  used  as  previously 
defined.  Reserve  for  Insurance  is  likely  on  any  balance  sheet  taken 


CHARACTERISTICS  OF  THE  BALANCE  SHEET    II 5 

up  at  random  to  mean  what  above  is  called  Allowance  for  Insur- 
ance. 

Reverting  now  to  our  specific  balance  sheet  on  page  1 10,  we  see 
that  both  the  assets  which  are  meant  as  provision  for  depreciation 
and  those  which  constitute  profits  withheld  for  general  purposes  of 
safety  are  set  aside  in  separately  labeled  funds;  that  the  depreci- 
ation fund  is  taken  out  of  product  for  the  replenishment  of  worn- 
out  real  estate  and  plant  (since  no  corresponding  item  appears  on 
the  credit  side),  and  that  the  reserve  fund  is  a  setting  aside  of 
profits  (for  the  corresponding  item  appearing  on  the  credit  side  of 
the  sheet  is  neither  investment  nor  borrowing,  and  we  have  no 
reason  to  assume  that  with  such  a  title  it  is  a  mere  deduction 
from  the  figure  of  overvalued  assets). 

We  have  up  to  this  point  followed  the  bookJieeping  rule  of  mak- 
ing no  subtractions  but  adding  deductions  to  the  contrary  side.  In 
reports  for  publication,  however,  it  is  often  desirable  to  disregard 
that  rule,  for  many  readers  are  misled  by  bookkeeping  rules.  The 
accounts  just  discussed  as  "allowances,"  or  deductions  from  assets, 
may  well  be  entered  on  balance  sheets  on  the  assets  side  and  there 
be  subtracted  in  short-extension,  thus: 

Real  Estate  $75,000 

Allowance  for  Depreciation  5, 000    $70,000 

This  should  mean  that  the  item  of  depreciation  is  actually  on  the 
books  as  a  credit. 

The  next  item  on  our  balance  sheet  is  Bills  Receivable.  It 
may  well  be  noted  here  that  this  account  is  coming  to  be  widely 
called  '' Notes  Receivable,"  and  its  opposite  "Notes  Payable.'^ 
These  titles  are  better  so  far  as  they  are  less  likely  to  be  inter- 
preted as  for  book  accounts  (bills  outstanding);  but  they  are 
less  good  when  drafts  or  bills  of  exchange  are  included  in  the 
accounts;  for  though  a  draft  is  a  bill  receivable  it  is  not  a  note 
receivable.  The  older  title  fits  into  the  old  commercial  usage  of 
speaking  of  all  promises  to  pay  as  "bills."  About  the  amount  of 
this  item  there  should  be  no  question,  for  notes  should  always 
be  entered  at  face  value;  but  about  the  real  value,  that  is,  the 
amount  that  can  be  collected,  there  may  be  much  question. 
Hence  the  item  appearing  upon  the  balance  sheet  is  comparatively 
of  little  significance  to  an  outsider  unless  he  learns  the  names  of  th« 


Il6  ACCOUNTS 

makers  of  the  notes  with  the  amounts  signed  by  each.  In  that  case 
mercantile  agency  reports  can  furnish  the  basis  for  the  estimate  of 
value.  An  assistance  in  estimating  the  value  of  these  notes  is  a  state- 
ment of  how  many  are  renewals,  that  is,  how  many  represent  pay- 
ments deferred  beyond  the  time  originally  agreed  upon  for  payment ; 
for  presumably  a  man  who  cannot  pay  at  the  time  agreed  upon  is  in 
financial  straits.  One  thing  is  sure,  unless  the  bills  receivable  are 
unusually  good  some  of  them  are  likely  in  the  long  run  to  prove 
uncollectible  and  some  provision  should  be  made  for  loss.  That 
provision  can  hardly  be  made  by  revaluing  the  bills  receivable, 
for  bringing  down  a  new  valuation  would  throw  Bills  Receivable 
out  of  correspondence  with  the  amount  of  notes  on  hand.  The  doubt 
cast  upon  the  bills  receivable  is  really  doubt  cast  upon  the  profit 
and  loss  account,  or  Surplus,  or  Undivided  Profits.  The  reason  for 
this  is  obvious,  since,  as  we  saw  some  time  ago,  the  profit  and  loss 
account  on  the  balance  sheet  represents  simply  excess  of  resources 
over  investment  and  borrowing.  Any  doubt  cast  on  the  value  of 
those  resources  is  doubt  cast  on  the  profit  and  loss  balance.  The 
wise  thing,  not  done  in  this  case,  is  to  charge  to  Profit  and  Loss,  as 
a  cost  of  doing  business,  an  estimate  of  shrinkage  for  the  period, 
and  to  credit  Allowance  for  Bad  Debts.  This  latter,  like  Allowance 
for  Depreciation,  is  a  deduction  from  the  book  valuation  of  assets 
—  but  here  not  objectionable,  for,  as  indicated  above,  one  can- 
not write  down  the  bills  receivable.  The  treatment  of  Allowance 
for  Bad  Debts  is  discussed  later.  How  large  a  percentage  of  Bills 
Receivable  can  be  safely  counted  good  will  depend  on  several  cir- 
cumstances. Of  course,  the  notes  held  by  a  conservative  house  are 
likely  to  prove  better  than  those  held  by  one  of  mushroom  tenden- 
cies. The  percentage  will  vary  in  different  lines  of  business.  In- 
deed, it  may  differ  as  much  as  30%  between  different  industries. 
This  is  all  we  can  say  in  general  terms  of  the  Bills  Receivable  on 
the  balance  sheet.  It  is  perfectly  proper  for  a  man  who  has  been  in- 
vited to  invest  in  a  corporation  or  to  lend  to  it  to  ask  to  see  its  biUs 
receivable.  How  large  a  proportion  should  be  considered  good  is 
a  matter  for  judgment,  and  a  man  may  properly  demand  a  good 
basis  upon  which  to  exercise  his  own  judgment  and  refuse,  without 
implied  discourtesy,  to  accept  any  other  man's. 

Our  next  item,  Accounts  Receivable,  is  so  nearly  allied  to  Bills 


CHARACTERISTICS  OF  THE  BALANCE  SHEET        II 7 

Receivable  that  practically  the  same  things  may  be  said  of  it.  How 
many  will  prove  good  will  depend  upon  conditions,  and  on  what 
basis  the  item  should  be  valued  is  a  matter  for  individual  judgment, 
A  considerable  difference  in  the  amount  and  value  of  Accounts  Re- 
ceivable is  likely  to  be  found  in  different  seasons  of  the  year  and  in 
different  trades.  In  some  trades  the  holdings  are  lightest  at  about 
the  time  of  the  new  year ;  in  others,  that  is  the  time  of  the  heaviest 
holdings.  In  some  Hnes  of  business,  book  accounts  (accounts  re- 
ceivable are  called  book  accounts  because  the  evidence  of  debt  lies 
in  the  books  and  not  in  a  note  or  other  document)  will  average  60% 
uncollectible,  and  in  others  80%  on  the  average  will  be  collectible. 

Two  differences  between  Bills  Receivable  and  Accounts  Receiv- 
able may  be  in  some  conditions  important.  A  bill  receivable  is  some- 
times endorsed  by  a  third  party,  who  thereby  guarantees  payment  if 
the  first  party  fail.  Such  bills  receivable  are  better  than  accounts  re- 
ceivable to  the  extent  of  the  better  security.  Again,  a  note  is  evidence 
that  the  debtor  has  recognized  the  debt  and  its  amount,  whereas  a 
book  account  may  be  disputed.  It  would  generally  appear,  therefore, 
that  when  one  is  judging  the  solvency  of  a  business,  bills  receivable, 
are  preferable  to  accounts  receivable.  There  is,  nevertheless,  one 
advantage  in  an  account  receivable  over  a  bill  receivable,  and  that, 
under  some  conditions,  may  be  worth  recognition.  The  man  who 
has  paid  his  debt  by  means  of  a  note  is  relieved  of  his  responsibiUty 
for  the  original  debt,  and  stands  Hable  merely  for  payment  on  the 
note.  The  goods  for  which  he  incurred  the  debt  cannot  therefore 
be  reclaimed  by  the  seller,  except  as  any  property  of  his  may  be 
seized  for  debt.  If,  on  the  other  hand,  he  has  not  given  a  note,  his 
liability  stands  on  the  books  in  relation  to  specific  property,  and  this, 
under  some  legal  conditions,  the  seller  may  claim. 

Of  the  supplies,  the  balance  sheet,  or  the  text  accompanying  it, 
should  show  the  basis  for  the  valuation.  Normally,  supplies  maybe 
figured  at  cost,  for  presumably  they  are  to  be  worked  up  into  other 
forms,  —  and  this  in  fact  is  what  they  were  bought  for.  The  more 
nearly  they  are  in  the  shape  of  raw  material,  rather  than  of  partly 
manufactured  material,  the  more  likely  they  are  to  prove  of  full 
value ;  for  styles  and  fads  seldom  affect  raw  material  so  as  to  render 
it  unserviceable,  though  they  very  seriously  affect  goods  that  have 
gone  through  even  slight  manufacturing  processes.    Of  course,  if 


Il8  ACCOUNTS 

supplies  are  inventoried  at  cost,  care  must  be  taken  that  only  net 
cost  is  included,  —  that  is,  that  all  discounts  have  been  subtracted 
whether  those  discounts  were  actually  received  or  not.  This  mat- 
ter of  discounts  in  relation  to  inventories  is  of  considerable  import- 
ance. It  will  be  discussed  in  detail  in  Chapter  XXI,  page  340.  It 
is  sufficient  for  our  purpose  here  to  note  the  outcome  of  it  all.  If 
business  managers  were  to  inventory  supplies  at  cost  to  them,  irre- 
spective of  discounts  that  they  took  or  might  have  taken,  the  concern 
with  the  best  means  and  best  management  would  invariably  show 
the  lowest  inventory  for  the  same  supplies ;  for  such  a  concern,  taking 
all  discounts  offered,  would  inventory  at  the  lowest  price,  and  a 
concern  with  scant  means  and  poor  management  would  neglect 
discounts  and  would  inventory  at  the  maximum  billed  price :  hence 
the  absurdity  that  the  poorer  concern  would  make  the  better  show- 
ing. The  escape  is  to  inventory  all  items  of  this  sort  at  the  minimum 
price. 

The  next  item  on  our  balance  sheet  is  Cash.  It  seems  as  if  this 
requires  no  comment,  and  yet  many  attempts  have  been  made  to 
juggle  with  it.  For  instance,  sometimes  the  item  reads  "cash  and 
cash  items.'*  "Cash  items"  may  mean  anything  under  the  sun.  It 
may  mean  a  slip  of  paper  in  the  cash  drawer,  containing  a  memo- 
randum that  Sio,ooo  has  been  paid  out  on  a  bond,  or  that  50  0  has 
been  paid  for  car  fare ;  or  it  may  mean  that  there  has  been  deposited 
in  the  cash  drawer  a  note  on  which  the  money  may  be  collected  some 
time.  In  a  conspicuous  case  made  public  a  number  of  years  ago, 
these  cash  items  included  more  than  half  a  million  dollars  of  worth- 
less claims  maintained  simply  to  pad  the  assets.  Any  one  invited 
to  invest  in  a  corporation  should  demand  a  full  explanation  of  any 
such  items.  Some  corporations  avoid  the  possibility  of  misunder- 
standing by  stating  exactly  where  their  cash  is  to  be  found,  naming 
the  amount  on  deposit  with  different  banks  and  trust  companies, 
etc.,  and  stating  the  amount  actually  in  the  company's  own  vaults. 
This  is  proper  reporting. 

Next  we  have  Merchandise.  A  few  fundamental  principles  are 
worth  attention.  First,  every  increase  in  the  valuation  set  upon 
merchandise  at  the  end  of  this  year  means  a  smaller  figure  of  profit 
next  year.  The  figure  of  merchandise  profit  is  determined  by  adding 
merchandise  inventory  to  merchandise  credits,  and  subtracting  the 


CHARACTERISTICS  OF  THE  BALANCE  SHEET         II9 

merchandise  debits.  That  is  to'say,  the  sales,  plus  the  merchandise 
unsold,  less  the  cost  of  that  which  was  purchased  and  the  inven- 
tory at  the  beginning  of  the  year,  must  show  the  gain.  If  the  inven- 
tory at  the  end  of  the  year  is  put  at  an  exaggerated  figure,  the  total 
of  sales  and  inventory  is  exaggerated,  and  since  this  is  the  sum 
from  which  the  cost  is  subtracted,  the  gain  is  exaggerated.  In  the 
next  year,  however,  what  was  in  the  previous  year  a  closing  in- 
ventory is  an  opening  inventory,  and  is  one  of  the  items  to  be 
deducted  as  cost.  Its  previous  exaggeration  as  a  value  in  the  busi- 
ness now  means  an  exaggeration  of  cost;  and  the  resulting  profit 
is  less.  This  can  be  illustrated  forcibly  by  a  condensed  merchan- 
dise account  for  three  years,  assuming  identical  figures  for  all  but 
the  inventories. 

Merchandise 

1915 


1916 


Balance 
Purchases 
Profit  and  Loss 

15,000 
100,000 

50,000 
165,000 

15,000 
100,000 

S5,ooo 
170,000 

20,000 
100,000 

45,000 
165,000 

Sales 
Inventory 

Sales 
Inventory 

Sales 
Inventory 

150,000 
15,000 

Balance 
Purchases 
Profit  and  Loss 

165,000 

150,000 
20,000 

Balance 
Purchases 
Profit  and  Loss 

170,000 

150,000 
15,000 

165,000 

1917 


Here  we  may  assume  $15,000  to  be  a  normal  valuation  of  the 
merchandise  —  that  which  was  taken  at  the  close  of  19 14  and  also 
at  the  close  of  191 5.  The  profits  on  merchandise  are  then  $50,000. 
If  optimism  governs  the  next  inventory  and  it  is  put  at  $20,000, 
profits  jump  to  $55,000.  This  $20,000  inventory  is  the  first  debit 
for  merchandise  in  the  next  year,  however,  and  then  unless  the 
inventory  is  again  overvalued,  the  profits  are  reduced  to  $45,000  — 
a  drop  of  $10,000  in  the  profits  with  a  drop  of  only  $5,000  in  the 
inventory.  In  other  words,  a  part  of  the  profits  actually  realized 
only  in  191 7  were  reported  as  if  realized  in  1916,  and  hence  could 
not  be  reported  when  actually  realized  in  191 7.  Only  conservative 
valuation  will  protect  a  business  against  taking  its  profits  before 
they  have  been  earned  —  profits  possibly  that  never  will  be  earned. 
The  second  principle  of  valuing  merchandise  is  that  only  the 


I20  ACCOUNTS 

lowest  net  figures  of  cost,  after  all  discounts  have  been  subtracted, 
should  be  used.  The  reason  for  this  is  explained  in  connection  with 
supphes  above.  Third,  very  few  stocks  of  merchandise  are  worth 
what  they  cost.  There  is  usually  some  loss  in  mere  handhng, — 
breakage  and  shop  wear.  There  is  decided  loss  in  many  lines  of 
business  from  change  of  fashion.  Some  estimates,  made  by  experi- 
enced appraisers,  of  the  average  value  of  stock  in  trade  in  different 
lines  of  business  give  for  some  trades  but  50%  of  cost,  and  for  others 
as  high  as  95%.  Groceries,  for  instance,  are  generally  standard 
articles  and  do  not  commonly  depreciate  rapidly.  Dry  goods  and 
millinery  are  much  subject  to  change  of  fashion,  although  even  in 
the  dry-goods  trade  some  kinds  of  fabrics  are  much  subject  to  change 
and  others  very  little;  figured  silks,  for  instance,  may  soon  prove 
unsalable,  but  cotton  sheeting  practically  never.  Again,  a  business 
must  necessarily  always  carry  a  certain  amount  of  dead  stock.  The 
stock  was  bought  to  satisfy  all  classes  of  customers  and  the  actual 
proportionate  demand  of  each  class  no  one  can  ever  exactly  predict. 
Intelligent  customers  go  where  they  are  practically  sure  to  find  what 
they  want,  rather  than  to  the  store  which  is  usually  "out  just  now." 
A  good  stock  of  goods  must  always  supply  more  variety  than  the 
pubUc  wants,  rather  than  less,  merely  to  be  on  the  safe  side ;  and 
that  excess  serves  as  a  sort  of  advertising  to  draw  or  keep  cus- 
tom. This  cost  is  a  part  of  the  cost  of  running  the  business  and  must 
be  charged  ultimately  to  loss.  A  distinction  must  be  made,  how- 
ever, between  a  valuation  made  for  purposes  of  closing  a  business 
and  one  made  for  a  business  as  a  going  concern.  A  firm  must  have 
an  excess  stock  of  goods  as  just  noted,  and  hence  a  valuation  for 
the  business  as  a  going  concern  may  adjudge  such  stock  to  be  worth 
nearly  cost;  but  an  appraisal  for  purposes  of  closmg  the  business 
entirely,  smce  such  goods  are  from  the  nature  of  the  case  not  in  com- 
mon demand,  must  put  them  at  a  very  low  figure. 

We  may  now  turn  to  the  liability  side  of  the  balance  sheet.  Of 
Capital  Stock  there  is  little  to  say.  Usually  the  figure  represents  the 
face  value  of  stock  outstanding.  Sometimes  instead  of  this  it  reports 
the  face  value  of  all  stock  authorized,  even  though  some  of  it  has  not 
been  issued.  In  such  a  case  the  facts  will  be  sufi&ciently  explained 
by  an  item  on  the  resource  side  of  the  balance  sheet  called  "Un- 
issued Stock  Authorized. '^  This  form  of  reporting,  however,  may 


CHARACTERISTICS  OF  THE  BALANCE  SHEET         121 

be  misleading,  for  innocent  readers  of  the  report  may  assume 
that  the  figure  given  represents  an  immediately  available  asset  — 
whereas  there  may  be  no  market  for  such  stock.  If  it  is  desired  to 
show  the  stock  authorized,  the  authorization  may  be  shown  short- 
extended  on  the  habihty  side  with  the  unissued  stock  subtracted. 
Sometimes  the  unissued  stock  is  reported  as  "Treasury  Stock." 
This  is  misleading,  for  the  term  ''Treasury  Stock"  should  be  used 
only  for  stock  once  issued  and  fully  paid  for,  but  now  held  in  the 
treasury  as  any  other  asset  may  be  held.  This  subject  is  further  dis- 
cussed in  Appendix  B,  Part  I. 

Concerning  Bills  Payable  and  Accounts  Payable  little  remark  is 
necessary.  They  are  debts  of  the  business  not  subject  to  shrinkage. 
One  item  closely  connected  with  Bills  Payable,  but  not  always  shown, 
is  often  of  great  importance.  Not  only  are  notes  sometimes  endorsed 
for  others,  but  commonly  bills  receivable  are  discounted  and  when 
discounted  must  be  endorsed.  If  any  of  the  notes  discounted  by  the 
business  prove  worthless,  they  must  be  redeemed.  Loss  on  worthless 
notes  cannot  be  shifted  to  some  one  else  by  the  mere  fact  of  discount. 
On  all  discounted  paper  outstanding,  therefore,  a  concern  has  a  con- 
tingent Uability.  Of  course,  this  element  of  doubt  applies  only  to  bills 
receivable  discounted  and  not  yet  due,  not  at  all  to  those  discounted 
and  since  paid.  A  method  of  estimating  the  element  of  doubt  is 
obvious.  Since  all  notes  discounted  have  been  recorded  with  the 
date  at  which  they  were  to  become  due,  the  amount  not  yet  paid  is 
easily  figured.  It  is  safe  to  assume,  in  the  absence  of  definite  infor- 
mation to  the  contrary,  that  all  endorsed  notes  payable  at  a  past 
date  were  paid  by  the  makers  when  due  and  therefore  that  the  lia- 
bility of  the  endorsers  has  ceased;  for  the  law  of  endorsement 
requires  the  holder  of  a  note  to  notify  the  endorser  at  once  in  case 
the  maker  fails  to  pay,  else  he  loses  all  claim  against  the  endorser. 
This  notice  is  commonly  called  "protesting  a  note,"  and  can  be 
given  only  through  a  pubHc  official,  such  as  a  notary  pubhc.  This 
sort  of  contingent  Habihty  need  be  figured,  then,  only  on  endorsed 
notes  not  yet  matured  and  on  protested  endorsed  notes,  if  any.  The 
amount  of  allowance  to  make  for  such  notes  would  naturally  be  the 
same  percentage  used  in  considering  the  value  of  bills  receivable 
on  the  resource  side  of  the  balance  sheet,  —  unless,  as  may  have 
happened,  the  firm  in  choosing  what  notes  to  discount  has  selected 


122  ACCOUNTS 

those  better  than  the  average.  This  contingent  liability  for  endorsed 
notes  obviously  ought  to  appear  on  the  balance  sheet.  When  a 
note  receivable  is  discounted,  the  natural  entry  is  to  debit  Cash 
and  credit  Bills  Receivable;  but  this  fails  to  record  the  contingent 
liabiHty.  As  discounting  a  note  does  not  necessarily  mean  that 
one  is  done  with  it,  one  should  not  credit  Bills  Receivable  as  if  one 
were  done  with  it.  An  interesting  situation  must  be  recorded.  If 
the  maker  of  the  note  and  the  prior  endorsers  fail  to  pay  it,  the  dis- 
coimter  must  redeem  it;  but  if  he  redeems  it,  he  gets  it  back  as  a 
bill  receivable  —  one  of  doubtful  value,  to  be  sure,  but  still  a  note 
receivable.  So  just  as  he  has  a  contingent  liability  as  endorser  after 
he  has  discounted  it,  he  has  a  contingent  asset  as  redeemer  — 
provided  the  contingent  Hability  ever  becomes  real.  Both  these 
facts  should  show  on  his  books.  If  when  he  discounts  the  note  he 
credits  Bills  Discounted,  rather  than  Bills  Receivable,  he  will  show 
a  new  liability  (known  to  be  contingent) ,  and  he  will  still  have  the 
old  assets  on  his  books  (known  to  be  also  contingent  by  exactly 
the  amount  of  Bills  Discounted).  This  is  as  it  should  be.  When  the 
time  of  maturity  arrives,  the  record  may  be  cleared  of  contingency: 
if  no  notice  of  protest  is  received  (allowing  reasonable  time  for 
communication),  liability  has  ceased,  and  a  debit  to  Bills  Dis- 
counted with  a  credit  to  Bills  Receivable  clears  both  accounts;  if 
notice  of  protest  is  received  and  the  discounter  redeems  the  note 
in  cash,  an  entry  debiting  Bills  Discounted  and  crediting  Cash 
clears  the  former  account,  and  the  old  debit  to  Bills  Receivable 
still  remains  to  show  the  possession  of  the  note.  Since  a  protested 
note  is  presumably  of  a  different  caHbre  from  unmatured  notes, 
however,  it  is  desirable  to  transfer  the  amount  of  this  note  to  a  new 
account.  This  is  done  by  debiting  Protested  Bills  and  crediting 
Bills  Receivable.  Then  the  old  records  are  clean  and  the  books 
show  that  really  a  new  situation  lies  in  the  possession  of  defaulted 
paper. 

If  notes  payable  are  secured  by  a  mortgage,  they  should  be  car- 
ried in  an  account  called  Mortgage  Notes  Payable,  so  that  a  special 
lien  on  assets  shall  be  shown  to  exist. 

A  liability  often  neglected,  but  of  great  importance,  is  that 
on  contracts  and  merchandise  for  future  delivery.  A  contract  signed 
in  December  for  raw  material  to  be  delivered  and  paid  for  in  Feb- 


CHARACTERISTICS  OF  THE  BALANCE  SHEET         1 23 

ruary  constitutes  one  of  the  liabilities  of  the  business  on  January  i. 
It  does  not  usually  appear  upon  the  books,  and  hence  cannot  ap- 
pear in  the  main  body  of  the  balance  sheet.  It  should  appear  in  a 
supplementary  statement  or  appended  note. 

The  next  item,  Reserve,  has  already  been  interpreted,  in  con- 
nection with  Real  Estate  and  Plant,  on  page  113. 

Profit  and  Loss,  as  shown  here,  is  a  proprietorship  account,  meas- 
uring the  excess  of  resources  over  specific  recognized  liabilities.  As 
explained  in  Chapter  V,  page  52,  this  figure  of  Profit  and  Loss  is 
derived  directly  from  the  books,  but,  except  for  the  lack  of  methods 
of  proof,  it  could  as  well  be  got  by  subtracting  resources  from  the 
other  HabiHties.  It  may  appear  under  any  one  or  more  of  several 
other  names,  —  Loss  and  Gain,  Surplus,  Undivided  Profits.  Obvi- 
ously here  the  $20,000  of  the  reserve  is  one  portion  of  profit  already 
subtracted  and  set  aside.  Commonly  a  reserve  is  for  a  specific  pur- 
pose, though  not  always;  a  surplus  is  usually  intended  to  be  per- 
manent; undivided  profits  are  usually  small  remainders  hardly 
worth  including  in  the  dividends;  the  items  represented  by  Loss  and 
Gain,  and  Profit  and  Loss,  are  not  usually  assigned  to  any  specific 
use  or  plan.  When  no  other  item  of  this  sort  appears,  as  Reserve 
or  Surplus,  it  is  evident  that  Profit  and  Loss  represents  the  ac- 
cumulated profits,  not  distributed  as  dividends,  of  all  the  years.  A 
debit  balance  for  this  item,  of  course,  signifies  a  deficit,  or  accumu- 
lated loss.  Changes  in  the  Profit  and  Loss  balance  not  explained 
by  the  income  sheet  should  be  shown  in  a  separate  statement. 

The  Surplus  may  include  capital  gains,  but  such  items  ought 
to  show  separately,  for  they  are  not  properly  available  for  divi- 
dends. When  such  surplus  is  actual  investment  in  excess  of  cap- 
ital stock,  as  in  the  case  of  stock  issue  at  a  premium,  the  amount 
should  be  carried  in  a  special  surplus  account,  as  shown  in  Ap- 
pendix B,  page  402.  Such  investment  should  never  be  confused 
with  earnings. 

An  interesting  confusion  has  arisen  in  the  minds  of  many  per- 
sons regarding  sinking  funds  established  out  of  Profit  and  Loss. 
The  significance  of  such  funds  will  be  clearer  after  we  have  consid- 
ered sinking  funds  established  from  other  sources.  Since  a  sinking 
fund  is  simply  a  sum  set  aside  to  be  increased  by  periodic  additions 
of  principal  and  accumulations  of  interest,  for  the  redemption  of 


124  ACCOUNTS 

some  future  obligation  or  the  retirement  of  some  asset,  the  source 
of  the  fund  cannot  affect  its  character.  One  may  borrow  from 
Peter  to  pay  Paul,  and  the  fund  established  by  the  borrowing  will 
be  no  less  a  sinking  fund  because  of  its  double  relation.  The  signifi- 
cant fact  is  that  one  does  not  by  the  borrowing  process  get  out 
of  debt.  A  sinking  fund  may  be  provided  also,  of  course,  by  diver- 
sion of  other  funds.  If  one  should  buy  property  by  borrowing,  one 
might  build  up  a  sinking  fund  for  the  payment  of  the  debt  by  carry- 
ing to  it  the  equivalent  of  the  depreciation  of  the  property;  so  that 
when  the  property  should  be  exhausted  the  fund  would  be  adequate 
to  pay  the  debt.  Such  a  fund  would  be  built  up  out  of  product, 
and  when  the  fund  should  be  used  for  its  purpose  nothing  would  be 
left.  In  effect,  the  property  would  have  been  borrowed,  and  when 
worn  out  its  equivalent  would  have  been  returned  to  the  lender. 
The  sinking  fund  then  would  be  a  temporary  device  and  would 
have  no  ultimate  effect.  This  would  be  equally  true  if  in  the  origi- 
nal borrowing  there  had  been  a  legal  requirement  that  such  a  fund 
should  be  set  aside  periodically  out  of  the  product.  At  the  culmi- 
nation of  such  a  condition,  before  the  application  of  the  fund,  the 
balance  sheet  might  appear  as  follows,  supposing  the  property  is 
not  written  off  but  an  allowance  for  depreciation  is  entered  as  a 
liability. 

Property  $50,000        Bills  Payable  $50,000 

Sinking  Fund         50,000        Allowance  for  Depreciation        50,000 

On  the  use  of  the  fund,  all  four  items  would  disappear  from  the 
sheet  —  the  allowance  would  cancel  the  property,  and  the  sinking 
fund  would  cancel  the  notes. 

If,  however,  the  sinking  fund  is  created  not  merely  out  of  prod- 
uct but  out  of  profits  (excess  product),  a  less  simple  situation  ap- 
pears. Suppose  out  of  product  enough  is  taken  to  provide  for  main- 
tenance, so  that  there  is  no  exhaustion  of  property.  This,  it  will  be 
noted,  is  simply  meeting  costs;  it  is  not  setting  aside  profits,  for 
there  are  no  profits  unless  the  product  can  replace  the  cost  of  prop- 
erty worn  out  in  production.  If  now,  however,  in  addition,  is  set 
aside  a  sinking  fund  out  of  surplus  product,  or  profits,  sufficient  to 
pay  off  debt  incurred  in  buying  the  property,  the  sinking  fund  will 
not  disappear,  except  in  name,  even  when  it  is  used  for  extinguish- 


CHARACTERISTICS   OF   THE  BALANCE   SHEET        1 25 

ing  the  debt.  The  fact  is  that  the  business  began  with  borrowed 
property  but  ends  with  owned  property.  It  has  appUed  its  sinking 
fund  to  paying  debt  and  has  done  this  without  depleting  other 
property  and  without  incurring  new  debt;  its  profits  consist  in  its 
freedom  from  debt.  An  apparent  paradox  lies  in  the  fact  that  the 
business  seems  to  have  used  its  profits  and  yet  to  have  those  profits 
remaining.  The  fact  is  that  using  profits  does  not  destroy  them; 
it  invests  them;  and  paying  debt  may  be  as  good  investment  as 
buying  property.  The  bookkeeping  situation  is  noteworthy.  Be- 
fore the  appHcation  of  the  sinking  fund  we  have  this  situation: 

Property  $50,000        Bills  Payable  Ss^^ooo 

Sinking  Fund  50,000        Reserve  for  Sinking  Fund  50,000 

When  the  fund  is  put  to  its  use,  it  cancels  the  Bills  Payable.  We 
have  remaining: 

Property  $50,000        Reserve  for  Sinking  Fund         $50,000 

Yet  there  is  no  sinking  fund,  and  there  is  no  error.  The  Reserve 
for  Sinking  Fund  is  a  nominal  account:  it  is  a  general  explanation 
of  the  presence  of  certain  assets  —  i.e.,  explanation  of  the  fact  that 
through  business  operations  assets  have  increased  faster  than  lia- 
bihty  for  either  borrowing  or  investment,  —  and  is  a  detailed  in- 
dication of  the  fact  that  this  increase  of  assets  is  not  intended  for 
dividends  but  for  reduction  of  debt.  When  actually  so  applied  the 
excess  assets  are  not  reduced,  for  gross  liabilities  go  down  with 
gross  assets,  and  net  assets  are  unchanged;  but  the  detailed  ex- 
planation now  takes  on  a  new  significance:  it  now  explains  the 
assets  themselves.  Originally  the  debt  explained  assets;  then  the 
reserve  for  sinking  fund  explained  the  sinking  fund ;  then  the  dis- 
appearance of  the  sinking  fund  explained  the  disappearance  of  the 
debt;  so  finally  the  Reserve  for  Sinking  Fund  is  left  to  explain  the 
assets  —  to  explain  that  they  are  free  assets  paid  for  out  of  profits. 
Since  the  change  of  circumstances  makes  the  title  now  misleading, 
however,  it  should  be  changed,  and  the  Reserve  for  Sinking  Fund 
may  be  transferred  to  General  Surplus.  The  original  labeling 
served  no  purpose  but  as  a  reminder  of  the  intention  of  the  com- 
pany to  apply  a  certain  amount  of  surplus  assets  to  a  certain  pur- 
pose. If  the  assets  are  properly  applied  the  surplus  is  not  reduced 
by  such  application. 


126  ACCOUNTS 

A  claim  of  a  business  that  it  must  get  high  prices  to  enable  it  to 
continue  its  sinking  fund,  then,  is  to  be  met  by  the  question,  What 
is  your  sinking  fund  for?  If  the  prices  will  not  keep  the  property 
intact,  or  provide  a  sinking  fund  for  replacement,  they  are  too  low; 
but  there  is  no  intrinsic  reason  why  they  should  provide  both  for 
maintenance  or  replacement,  on  one  hand,  and  for  a  sinking  fund 
that  will  pay  off  the  debt  incurred  in  acquiring  the  property.  A 
demand  for  the  latter  is  a  demand  not  only  that  prices  pay  for  the 
use  of  property  but  that  they  also  ultimately  supply  the  property 
itself  without  investment  by  the  holders.  Many  a  sinking  fund  has 
been  created  out  of  surplus  profits  when  it  was  believed  to  be  a 
liability  incurred  as  a  necessary  cost  of  doing  business.  The  fact 
that  there  may  be  a  legal  liability  to  set  aside  such  a  sinking  fund 
out  of  income  does  not  mean  that  by  it  ultimate  liabilities  are  in- 
creased. The  liability  to  outsiders  is  in  the  original  debt  already 
reported  among  the  other  liabiUties  on  the  balance  sheet,  and 
when  reported  again  it  obviously  cannot  be  for  the  same  debt;  the 
second  reporting  is  the  new  liabiHty  to  stockholders  for  profits 
reserved;  and  though  the  first  disappears  with  the  application  of 
the  assets  to  the  payment  of  debt,  the  second,  as  an  explanation 
of  how  the  corporation  acquired  so  many  net  assets,  cannot  disap- 
pear, except  by  transfer,  until  those  assets  are  lost  or  distributed 
in  dividends.  The  transfer  is  a  debit  to  Reserve  for  Sinking  Fund 
and  a  credit  to  Surplus. 

A  good  deal  of  tricky  business  has  been  kept  out  of  sight,  even 
when  detailed  balance  sheets  have  been  published,  under  the  guise 
of  branch  assets  and  liabilities.  The  possibilities  of  confusion  be- 
tween the  main  house  and  the  branch  are  numerous,  and  only  watch- 
fulness will  prevent  even  innocent  confusion.  The  only  possible 
assurance  of  correct  accounting  in  such  a  case  Hes  in  either  absolute 
separation  or  absolute  consolidation  of  the  accounts,  and  even  the 
latter  is  more  or  less  dangerous,  as  may  be  seen  by  reaUzing  that  the 
bills  payable  of  one  may  be  the  bills  receivable  of  the  other.  For 
example,  it  would  be  easy  to  count  a  debt  of  the  branch  as  a  resource 
to  the  main  house,  but  not  count  it  as  a  liability  of  the  branch  for  the 
plausible  reason  that  it  is  not  an  outside  liabihty.  Again,  the  main 
house  may  count  as  a  resource  the  notes  of  the  branch  payable 
to  the  main  house  for  merchandise,  and  also  count  as  a  resource  of 


CHARACTERISTICS   OF  THE  BALANCE  SHEET        12/ 

the  main  house  such  merchandise  in  the  warehouse  of  the  branch. 
A  little  sophistry  of  this  sort  enables  a  manager  to  count  favorable 
things  twice  and  unfavorable  things  perhaps  not  at  all.  Again,  the 
relation  of  parent  and  branch  may  enable  the  parent  to  show  a  good 
profit  at  the  expense  of  the  branch.  For  example,  the  main  house 
may  sell  goods  to  the  branch  at  such  prices  that  it  makes  a  big  profit 
for  itself,  but  leaves  the  branch  with  a  deficit.  If,  then,  the  affairs  of 
the  branch  are  not  pubHshed,  the  existence  of  the  deficit  is  hidden 
under  apparent  prosperity,  and,  although  the  condition  must  dis- 
close itself  in  time,  years  may  pass  before  the  deceit  is  discovered. 
This  sort  of  thing  may  be  done  not  only  to  show  a  good  profit  on  goods 
sold,  but  also  to  rid  the  main  house  of  unsalable  goods.  Goods  prov- 
ing unsalable  may  be  shipped  to  the  branch  and  recorded  as  stock 
on  hand,  while  even  an  expert  investigation  of  goods  in  the  main 
store  may  lead  to  a  report  that  all  goods  are  salable.  Unless  the  in- 
vestigation is  extended  to  the  branch,  the  ruse  is  Hkely  to  be  success- 
ful. These  misrepresentations  of  facts  as  between  a  parent  house 
and  its  branch  could  never  occur  under  correct  accounting.  Detec- 
tion is  simple  if  both  sets  of  books  and  both  sets  of  assets  are  ex- 
amined and  properly  compared. 

Let  us  now  take  the  balance  sheets  given  on  page  no,  with  the 
assumption  that  we  can  get  no  further  information  about  the  busi- 
ness —  having  not  even  the  income  sheet,  —  and  let  us  see  what 
we  can  learn  concerning  the  transactions  of  the  years  intervening 
between  the  three  reports. 

The  first  requirement  of  interpretation  is  a  realization  that  nothing 
is  either  increased  or  decreased  without  an  equivalent,  —  at  least  in 
double-entry  accounting,  and  that  is  our  only  concern  at  present. 

It  is  evident,  in  the  first  place,  that  an  increase  in  a  resource 
account  indicates  that  something  has  been  spent  to  acquire  that 
increased  resource.  Similarly,  a  decrease  in  a  liability  account  indi- 
cates the  same  sort  of  thing,  for  the  liability  must  have  been  paid  off, 
and  therefore  something  has  been  spent.  Conversely,  a  decrease  in 
a  resource  account  indicates  that  something  has  been  taken  from  this 
account  during  the  year  and  spent  elsewhere ;  or,  what  amounts  to 
the  same  thing,  this  decrease  is  part  of  an  exchange  of  one  asset  for 
another.  Similarly,  again,  an  increase  in  a  liability  account  indicates 
that  the  firm  has  borrowed  some  sort  of  property  and  hence  it  by  so 


128  ACCOUNTS 

much  has  had  means  to  spend.  By  making  a  comparison,  then,  of 
these  three  balance  sheets,  tabulating  the  increases  and  decreases 
of  resources  and  Habilities,  we  can  see  from  what  sources  all  receipts 
came  and  to  what  destination  all  expenditures  went.  In  making  this 
tabulation,  we  may  well  give  any  one  of  three  titles  to  each  column. 
Let  us  call  the  first  column  credits,  or  receipts,  or  '* where  got" ;  the 
second  column  we  may  call  debits,  or  expenditures,  or  "  where  gone." 
Clearly,  if  any  account  on  either  side  of  the  balance  sheets  remains 
at  the  same  figure  in  any  year  as  in  the  preceding  year,  however 
many  transactions  may  have  taken  place  in  that  account  we  need 
take  no  thought  of  them^  for  the  net  result  was  to  leave  the  account 
as  before ;  so  we  are  concerned  only  with  changes. 

We  will  take  one  year  at  a  time.  Turning  to  the  first  account  on  the 
balance  sheet,  Real  Estate  and  Plant,  we  find  that  between  1905  and 
1906  it  increased  $145,000.  This  increase  in  the  resources  shows 
where  something  has  gone,  and  therefore  it  may  go  into  the  second 
column  of  our  tabulation  (page  131),  sufficiently  indicated  by  the 
words  ''Real  Estate  and  Plant,  +145,000."  The  next  account, 
Bills  Receivable,  shows  an  increase  of  $52,000.  This  also  shows 
where  something  has  gone,  because  if  that  item  has  increased  by 
$52,000  the  firm  must  have  acquired  this  claim  by  some  means,  and 
the  increase  indicates  that  property  has  gone  in  that  direction  to  that 
amount.  We  tabulate  it  in  the  second  column.  Accounts  Receiv- 
able is  similar.  The  next.  Supplies,  has  shrunk  $10,000.  This 
means  that  $10,000  worth  of  supplies  has  been  taken  from  the  store- 
house and  put  to  some  use.  In  other  words,  the  firm  has  got  $10,000 
from  that  source.  Hence  the  item  is  written  in  the  first  column  of 
our  tabulation  as  "  Supplies,  —10,000."  The  next  item  is  a  cash 
shrinkage  of  $260,000.  This  means  that  there  was  at  the  beginning 
of  the  year  in  the  bank  or  in  the  office  $300,000,  of  which  $260,000 
has  been  taken  out ;  and,  therefore,  this  account  has  furnished  to  the 
business  this  amount  of  money,  which  may  now  be  represented 
in  the  column  headed  "where  got,"  as  "Cash,  —260,000."  Mer- 
chandise has  jumped  from  nothing  to  $105,000.  In  other  words,  the 
firm  has  just  begun  business  and  has  acquired  in  the  course  of  a  year 
by  manufacturing,  or  purchase,  or  borrowing,  $105,000  worth  of 
merchandise  that  must  be  accounted  for.  We  know  only  that  this 
amount  of  $105,000  indicates  how  some  resources  have  been  spent, 


CHARACTERISTICS  OF  THE  BALANCE  SHEET    129 

and  therefore  the  amount  should  appear  in  the  second  column  as 
"Merchandise,  +105,000." 

On  the  credit  side  of  the  balance  sheet  the  first  change  is  an  increase 
in  Accounts  Payable  to  the  amount  of  $20,000.  This  can  mean  only 
that  the  firm  had  among  its  book  debts  at  the  end  of  the  year 
$20,000  which  it  did  not  have  at  the  beginning  of  the  year ;  and  this 
borrowing  has  enabled  it  to  acquire  certain  assets.  Therefore  this 
increase  should  be  entered  in  the  first  column  among  the  receipts  as 
"Accounts  Payable,  +20,000."  The  only  other  change  in  this  year 
is  Profit  and  Loss,  $20,000.  This  means  that  the  business  has  earned 
$20,000  more  than  it  has  distributed  in  profits  (whether  anything  has 
been  distributed  in  profits  we  cannot  tell  from  the  balance  sheet). 
This  $20,000  has  been  earned  by  the  business.  In  what  form,  we  do 
not  know;  but,  in  any  case,  it  has  furnished  a  resource  by  which 
the  business  has  acquired  some  property.  Therefore,  it  should 
appear  in  the  first  column  under  receipts,  as  "Profit  and  Loss, 
+  20,000."  It  is  obvious  that  since  the  balance  sheet  for  1905  has  a 
correspondence  of  total  debits  with  total  credits  and  the  same  thing 
is  true  for  the  balance  sheet  for  1906,  the  differences  in  accounts 
between  the  balance  sheets  of  those  two  years  must  also  show  an 
equality  of  debits  and  credits.  If  we  now  compare  these  totals  as 
arranged  in  the  columns  we  shall  find  $310,000  on  each  side,  and 
our  examination  has  proved.  ^ 

Some  of  the  items  discussed  above  may  have  seemed  contradictory. 
It  should  be  noted  that  the  figures  we  are  using  do  not  in  themselves 
tell  us  anything  of  the  transactions  for  the  year  that  has  gone, — 
they  tell  only  what  is  the  present  condition  of  each  account.  An  in- 
crease in  present  resources  goes  down  in  our  table  not  among  the 
resources  but  among  the  expenditures,  —  that  is  to  say,  if  the  thing 
mentioned  as  a  change  is  now  on  hand,  it  was  not  used  as  a  resource 
during  the  year  gone,  but  was  the  cause  of  an  expenditure  for  its 
acquisition.  What  we  are  tabulating  is  not  the  things  got  and  the 
things  spent,  but  the  sources  and  the  destinations  of  the  getting  and 
the  spending.  In  our  table,  the  expression  "Accounts  Payable, 
+20,000,"  under  "Where  got,"  means  not  that  accounts  payable 

*  The  plus  and  minus  signs  in  the  table  do  not  mean  addition  and  subtraction,  but 
are  used  to  indicate,  for  reference,  increases  and  decreases.  A  decrease  in  assets  is  aa 
much  a  "  where  got "  as  is  an  increase  in  liabilities,  and  hence  the  two  are  added  to  give 
the  total. 


130  ACCOUNTS 

were  got,  but  that  this  item  explains  whence  some  of  the  things  in  the 
other  column  were  got.  The  columns  might  have  been  named 
"What  given"  and  "What  got"  —  the  former  being  equivalent  to 
"Where  got";  but  that  plan  would  have  been  confusing,  for  since 
profit  and  loss  and  the  reserve  fund  came  from  earnings,  nothing 
appearing  on  the  balance  sheet  was  given  in  exchange :  they  can  be 
listed  under  "Where  got,"  but  they  could  not  be  listed  under  "What 
given." 

For  the  second  year,  the  first  item,  Real  Estate  and  Plant,  shows 
a  shrinkage  of  $20,000.  This,  standing  alone,  may  be  due  to  either 
a  sale  of  property  or  allowance  for  depreciation.  That  is  to  say, 
either  the  property  has  been  exchanged  for  other  resources  or  it  has 
been  partly  worn  out  producing  something  in  its  place.  We  enter  it 
in  the  column  "Where  got."  The  next  account.  Bills  Receivable, 
and  the  next.  Accounts  Receivable,  show  each  a  shrinkage  of  $5000. 
Since  each  is  a  resource  that  has  shrunk,  it  has  given  up  some  pro- 
perty that  the  last  year  turned  to  its  own  usage ;  and  the  amounts  are 
entered  among  the  receipts  for  the  year  gone.  Cash,  which  has 
shrunk  $20,000,  is  in  the  same  class.  Merchandise  has  increased 
$20,000,  and  that  increase  explains  whither  other  resources  have 
gone ;  and  accordingly  the  item  is  tabulated  among  the  expenditures. 
Depreciation  Fund  appears  as  a  new  item  to  the  amount  of  $20,000, 
and  since  it  is  on  the  resource  side  of  the  sheet  it  must  indicate  a  real 
fund ;  this  fund  must  have  cost  something,  and  since  it  shows  where 
some  property  has  gone,  it  must  be  entered  as  an  expenditure.  The 
same  thing  is  true  of  Reserve  Fund  on  this  side  of  the  sheet.  Capital 
Stock  has  increased  $100,000.  This  is  clearly  a  receipt  for  the  year 
past,  for  the  issue  of  this  additional  $100,000  in  stock  must  have 
brought  some  return,  either  additional  resources  or  the  cancellation 
of  liability,  —  perhaps  liability  for  debt  or  perhaps  liability  for  earn- 
ings. Bills  Payable  has  disappeared  to  the  amount  of  $100,000,  and 
therefore  something  must  have  been  expended  to  close  that  account ; 
hence  the  item  appears  among  the  expenditures.  Similarly,  the  re- 
duction of  Accounts  Payable  explains  expenditures  to  the  amount  of 
$10,000.  Reserve  Fund,  appearing  this  time  on  the  credit  side  of  the 
sheet,  explains  that  profits  to  the  amount  of  $20,000  have  been  set 
aside,  and  since  these  profits  have  furnished  resources  for  the  busi- 
ness they  are  entered  among  the  receipts.  Taking  our  totals  of  these 


CHARACTERISTICS   OF  THE   BALANCE   SHEET 


131 


two  columns,  we  find  the  correspondence  of  $170,000,  proving  our 
work.  The  size  of  these  totals  is  of  little  consequence,  for  it  bears 
very  little  relation  to  the  amount  of  business  done.  Many  changes 
in  the  balances  of  assets  and  liabilities  may  occur  in  dull  years,  and 
few  in  busy  years. 

Summary  of  Transactions  as  shown  from  the  Balance  Sheets  on  Page  no 

Where  got  Where  gone 

{or  {or 

Receipts  Expenditures 


or 

or 

Credits) 

Debits) 

I 

906 

Supplies 

-   10,000 

Real  estate  and  plant 

+  145,000 

Cash 

—  260,000 

Bills  receivable 

+   52,000 

Accounts  payable 

+   20,000 

Accounts  receivable 

+     8,000 

Profit  and  loss 

+  20,000 

Merchandise 

+  105,000 

310,000 

310,000 

I 

907 

Real  estate  and  plant 

—  20,000 

Merchandise 

+   20,000 

Bills  receivable 

-     5,000 

Depreciation  fund 

+  20,000 

Accounts  receivable 

-     5,000 

Reserve  fund 

+   20,000 

Cash 

—  20,000 

Bills  payable 

—  100,000 

Capital  stock 

+ 100,000 

Accounts  payable 

—   10,000 

Reserve  fund 

+  20,000 
1 70,000 

1 70,000 

So  it  is  possible  always  to  draw  certain  conclusions,  from  very 
simple  balance  sheets,  concerning  transactions  carried  on  in  the 
intervening  year.  Of  course,  it  is  not  commonly  possible  to  know 
that  a  particular  Sio,ooo  from  among  the  receipts  was  devoted  to  a 
particular  $10,000  among  the  expenditures.  No  exact  correspond- 
ence of  item  for  item  can  be  expected ;  but  many  strong  presumptions 
are  sometimes  offered,  as  when,  in  the  above  figures,  $100,000  in- 
crease in  capital  stock  corresponds  with  a  $100,000  disappearance 
of  bills  payable.  The  figures  suggest,  of  course,  a  conversion,  either 
direct  or  indirect,  of  floating  debt  into  capital  stock.  Sometimes  the 
conversion  of  one  type  of  asset  or  liability  into  another  is  of  great 
importance,  for  it  may  affect  general  solvency. 

It  must  be  remembered  that  such  a  study  of  the  balance  sheet  gives 
no  indication  of  the  amount  of  earnings,  for  earnings  which  have 


132  ACCOUNTS 

been  distributed  as  dividends  cannot  possibly  affect  a  balance  sheet; 
they  appear  on  the  income  sheet  only.  The  only  indication  that  the 
balance  sheet  can  give  is  of  the  earnings  undistributed,  as  shown  in 
Profit  and  Loss  or  some  similar  account. 

Such  a  table  as  that  which  we  have  been  constructing  was  prac- 
tically unknown  in  pubHshed  reports  until  about  five  years  ago ;  each 
year  since  that  time  one  or  more  railroads  have  added  something 
of  this  sort  to  their  exhibits,  usually  under  such  a  title  as  "Sum- 
mary of  Financial  Transactions  for  the  Year." 

It  is  obvious  that  an  important  result  of  constructing  such  a  table 
as  that  given  above  is  the  possibiHty  of  seeing  from  it  at  a  glance  the 
changes  in  solvency.  Certain  kinds  of  assets  are  always  good,  certain 
kinds  are  sometimes  bad,  and  a  few  kinds  are  usually  bad.  Certain 
kinds  of  liability  are  not  suspicious,  and  certain  other  kinds  are  often 
so.  A  summary  table  showing  the  changes,  as  above,  indicates 
whether  good  assets  are  exchanged  for  less  good,  and  whether  trouble- 
some liabilities  are  exchanged  for  those  that  are  less  exacting.  For 
example,  an  exchange  of  cash  for  accounts  receivable,  dollar  for 
dollar,  is  a  sure  sign  of  loss  (supposing  all  other  items  to  be  the  same, 
of  course) :  and  a  conversion  of  bills  payable  into  undivided  profits 
is  an  indication  of  gain ;  for,  if  all  other  items  remain  the  same,  this 
must  mean  that  a  debt  to  outsiders  has  been  paid  off  out  of  profits, 
i.e.,  without  impairing  last  year's  assets,  and  so  the  free  assets 
are  so  much  the  greater. 

The  principles  discussed  may  well  be  applied  at  this  point  to  im- 
aginary reports  of  a  number  of  different  concerns,  especially  in  a 
comparison  of  the  solvency  of  those  concerns.* 

Now,  to  take  these  in  order,  we  may  examine  the  probable  truth 
of  the  figures  given.  The  first  item  worthy  of  attention  is  Real 
Estate  with  C  D  Co.  We  find  this  to  be  increasing  year  by  year,  and 
it  happens  that  the  increase  each  year,  in  the  two  years  which  we 
can  trace  on  the  balance  sheets,  is  exactly  equal  to  the  sum  spent  for 
repairs.  This  looks  a  little  suspicious,  as  if  the  firm  were  charging  to 
the  capital  account  what  should  have  been  charged  to  revenue ;  but 
unless  we  can  get  access  to  the  record  we  can  get  no  exact  information. 
We  must  hold  judgment  in  abeyance,  therefore,  until  we  see  what 
general  impression  we  can  get  of  the  trustworthiness  of  the  books. 
^  For  the  figures  see  pp.  134  and  135. 


CHARACTERISTICS   OF  THE   BALANCE   SHEET         I33 

In  the  merchandise  account  on  the  balance  sheet  of  the  C  D  Co., 
we  find  a  rather  rapid  increase  in  the  amount  on  hand  at  the  end  of 
the  year.  This  is  not  in  itself  suspicious,  but  it  should  bear  some 
relation  to  the  amount  of  sales.  We  find  the  sales  of  this  firm  are 
increasing  in  the  first  year  2^%,  but  the  stock  on  hand  has 
increased  25%.  In  the  next  year  the  sales  have  increased  less  than 
4%,  but  the  stock  on  hand  has  increased  20%.  The  natural  con- 
clusion is  that  the  firm  is  accumulating  dead  stock.  The  stock, 
moreover,  is  valued  at  100%  of  cost.  Even  under  the  best  of  cir- 
cumstances this  is  excessive.  Yet  this  concern  paid  high  prices :  it 
took  fewer  discounts  than  its  neighbors.  In  marked  contrast  is  the 
condition  for  E.  F.,  with  whom  the  sales  have  increased  25%  in  the 
first  year,  but  the  stock  on  hand  not  at  all.  In  the  next  year  the  sales 
have  increased  20%,  and  the  stock  not  at  all.  The  conclusion  is, 
inevitably,  that  E.  F.  is  able  to  increase  his  sales  without  increasing 
his  stock,  so  that  he  is  either  buying  more  skillfully  or  seUing  more 
vigorously.  He  values  merchandise  at  a  low^r  percentage  and  takes 
many  discounts.  A  B  Co.  presents  very  much  the  same  condition 
as  E.  F.,  though  not  in  quite  so  striking  a  fashion. 

C  D  Co.  shows  also  a  rapidly  increasing  amount  of  bills  receivable 
and  accounts  receivable,  out  of  proportion  to  the  increase  in  sales. 
This  is  accompanied,  moreover,  by  a  considerable  increase  in  the 
loss  by  bad  debts,  and  by  a  rapid  decrease  in  the  discounts  given. 
The  conclusion  is  inevitable  that  many  of  its  bills  receivable  are 
renewals  or  extensions,  and  that  its  customers  are  generally,  as 
indicated  by  the  few  discounts  given,  of  a  class  having  inferior 
credit. 

In  the  matter  of  fittings,  C  D  Co.'s  increase  in  the  last  year  is 
without  apparent  reason.  No  part  of  the  business  shows  need  for 
an  increase  of  store  facihties.  One  has  suspicions  that  it  has  arisen 
simply  from  ''writing  up"  that  account,  or  from  charging  repairs 
to  capital. 

C  D  Co.'s  shrinkage  of  cash  and  increase  in  liabilities  are  at 
least  suspicious. 

A  few  comments  are  worth  while  in  connection  with  the  income 
sheet.  Here  we  have  no  means  of  forming  any  judgment  except 
by  comparison.  It  is  obvious  that  the  discounts  given  in  this  trade 
are  small  or  few;  but,  whereas  A  B  Co.  and  E.  F.  have  a  business 


134 


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CHARACTERISTICS   OF   THE   BALANCE    SHEET       I35 


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136  ACCOUNTS 

of  not  more  than  twice  that  of  C  D  Co.,  their  discounts  given  are 
many  times  as  great,  and  whereas  the  discounts  which  they  have 
given  are  increasing,  the  discounts  given  by  C  D  Co.  are  decreasing 
rapidly,  indicating  a  poor  class  of  custom;  and  whereas  the  dis- 
counts taken  by  C  D  Co.  are  very  small  and  not  increasing,  the 
discounts  taken  by  the  others  are  increasing  steadily.  In  other 
words,  C  D  Co.  is  losing  at  both  ends  of  its  business,  both  on  goods 
purchased  and  on  sales. 

These  later  conclusions  regarding  the  condition  of  C  D  Co. 
rather  confirm  our  early  suspicion  with  regard  to  charges  to  real 
estate  and  to  fittings.  If,  now,  the  doubtful  items  are  to  be  "written 
off"  the  assets  of  C  D  Co.  and  then  subtracted  from  the  net  earn- 
ings, as,  of  course,  must  be  done  if  they  have  been  charged  to  capi- 
tal when  they  should  have  been  charged  to  revenue,  we  get  the 
rather  striking  conclusion  that  the  net  earnings  for  the  year  ending 
December  31,  1906,  were  not  $11,000,  as  reported,  but  only  $4000, 
and  that  the  surplus,  reported  as  $8000,  was  really  a  possible  deficit 
of  $500. 

Before  passing  to  the  revision  of  the  figures,  to  enable  us  to  con- 
struct more  accurate  sheets  than  the  ones  offered,  a  few  general 
comments  are  worth  while.  The  A  B  Co.'s  sales  are  for  the  last 
year  130%  of  its  capital;  the  C  D  Co.'s,  160%;  E.  F.'s,  750%.  In 
available  assets  and  sales,  A  B  Co.  is  holding  its  own  and  slowly 
improving,  and  is  decreasing  its  outside  debt ;  C  D  Co.  on  paper 
shows  about  the  same  condition  of  sales,  but  its  assets  are  each 
year  of  a  more  doubtful  character  (bills  receivable  and  accounts 
receivable,  with  less  cash),  and  its  liabiKties  are  rapidly  increas- 
ing ;  E.  F.  shows  remarkable  sales,  and  assets  which,  though  slightly 
shrunk  in  amount,  —  suggesting  a  liberal  writing  off  of  the  doubt- 
ful parts,  —  are  rapidly  changing  in  character  from  uncertain  to 
secure  (bills  receivable  to  cash),  and  are  set  off  against  liabihties 
decreasing  rapidly.  A  B  Co.'s  class  of  custom  is  improving,  as 
indicated  by  the  decreasing  losses  by  bad  debts  and  the  discounts 
given;  C  D  Co.'s  is  rapidly  declining,  with  a  decreasing  expense 
to  suggest  incompetent  or  untrustworthy  salesmen;  E.  F.'s  is  im- 
proving. 

Let  us  now  attempt  to  revalue  the  assets.  The  only  doubt  in  the 
case  of  A  B  Co.  is  the  valuation  of  merchandise.    The  percentage 


CHARACTERISTICS  OF  THE  BALANCE  SHEET    1 37 

of  cost  used,  95,  is  rather  high,  but  the  company  has  either  written 
off  some  dead  stock  or  managed  to  run  along,  with  increasing  sales, 
on  a  smaller  stock ;  and  we  are  therefore  justified  in  passing  it. 

With  C  D  Co.  we  find  things  far  different.  The  merchandise  is 
valued  at  100%  of  cost,  necessarily  excessive;  and  that,  too,  in  spite 
of  evidence  of  accumulated  dead  stock  and  highest  prices.  We 
are  justified  in  docking  that  item  at  least  $3000.  The  bills  receiva- 
ble and  the  accounts  receivable,  in  view  of  the  increasing  losses 
incurred  in  the  past  few  years,  the  indication  of  still  poorer  custom 
now  on  the  books,  and  the  excessive  increasing  basis  of  valuation 
actually  used,  should  be  reduced  by  at  least  $2000  each.  We  are 
now  justified  in  refusing  to  allow  the  full  increase  in  real  estate 
and  in  fittings,  for  the  books  have  shown  a  false  basis  of  valuation 
throughout.  A  liberal  allowance  for  these  would  justify  writing 
off  at  least  $1500  more,  or  $8500  in  all.  When  applied  to  the  sur- 
plus of  $8000,  we  find  a  net  result  of  $500  deficit.  Applying  the 
same  principles  to  net  earnings,  we  shall  consider  about  $7000  of 
the  $8500  as  belonging  properly  to  the  last  year,  leaving  a  net 
earning  of  $4000.  Of  course  these  are  but  rough  estimates  and 
cannot  be  defended  in  exact  detail,  but  any  one  asked  to  accept, 
as  a  basis  for  any  credit  transaction,  the  figures  first  given,  would 
be  obliged  to  oft'er  some  arbitrary  scheme  of  reduction  unless  he 
could  get  access  to  the  original  documents. 

Of  E.  F.'s  affairs  little  is  to  be  said.  Though  both  bases  of  valu- 
ation are  high,  the  improving  conditions,  the  effective  stock  of 
goods,  and  the  low  figure  of  losses,  justify  us  in  taking  it  on  faith. 

The  defective  accounting  of  C  D  Co.  illustrates  a  point  previ- 
ously mentioned.  Sometimes  a  distinction  is  made  between  a  bal- 
ance sheet  and  a  "Statement  of  Resources  and  Liabilities."  Any 
difference  that  can  exist  between  two  such  statements  must  be  due 
to  the  fact  that  the  books  do  not  faithfully  represent  the  conditions. 
The  debit  side  of  the  balance  sheet  should  be  a  statement  of  re- 
sources and  the  credit  side  should  be  a  statement  of  liabilities ;  but 
such  things  as  bills  receivable  and  accounts  receivable,  though  of 
doubtful  quality,  must  appear  on  the  books  at  face  value.  Neces- 
sary allowance  can  be  made  on  the  balance  sheet  without  throwing 
the  statement  out  of  accord  with  the  books.  If  each  year  a  sum 
equivalent  to  the  expected  shrinkage  in  such  items  is  subtracted 


138  ACCOUNTS 

from  income  and  credited  to  Allowance  for  Bad  Debts  (which  will 
appear  as  a  liability,  of  course),  the  balance  sheet  may  exactly 
represent  both  the  books  and  the  conditions.  Under  this  plan, 
losses  suffered  next  year  on  this  year's  business  would  be  debited 
to  that  account,  and  any  discrepancy  or  excess  between  the  esti- 
mated sum  and  the  actual  might  furnish  a  basis  for  a  better  judg- 
ment in  later  years.  Such  discrepancy  or  excess  might  be  closed 
into  Loss  and  Gain  of  the  year  following  the  estimate,  or  it  might 
be  carried  to  the  Surplus.  So  far  as  the  difference  is  due  to  espe- 
cially good  or  bad  methods  of  collection,  it  belongs  to  the  year  in 
which  the  collections  are  made ;  so  far  as  it  is  due  to  the  goodness 
or  the  badness  of  the  debts  themselves,  it  belongs  back  with  the 
last  year's  surplus  or  deficit. 

A  few  other  matters  in  connection  with  a  balance  sheet  are  worth 
considering  at  this  point.  Suppose  a  corporation  shows  a  balance 
sheet  with  undivided  profits  of  20%  of  the  capital  stock  and  the 
assets  are  known  to  be  conservatively  figured.  If  the  assets  prove 
to  be  worth  all  they  have  been  estimated  as  worth,  can  the  firm  go 
into  bankruptcy?  As  a  matter  of  fact,  many  firms  have  gone  into 
bankruptcy  under  just  such  conditions.  They  had  large  accumu- 
lations of  profits  and  those  profits  were  real.  Yet  bankruptcy 
followed  because  the  liabihties  happened  to  be  immediate  and 
the  resources  remote.  Sometimes  a  business  growing  rapidly  and 
profitably  is  of  such  a  nature  that  its  liabilities  are  for  early  pay- 
ment, whereas  its  resources  are  to  be  realized  late.  Book  publish- 
ing on  the  subscription  plan  is  a  good  illustration.  Ultimately, 
however,  in  a  case  of  this  sort,  a  reorganization  of  the  business  will 
permit  the  payment  of  one  hundred  cents  on  the  dollar.  A  bal- 
ance sheet  which  gives  no  hint  of  the  fact  that  the  habilities  are 
immediate  and  the  resources  remote  is  not,  therefore,  entirely  sat- 
isfactory. It  should  be  so  arranged  that  the  "quick  assets,"  as 
they  are  called,  can  be  compared  with  the  "current  liabilities." 
It  would  be  well  to  make  the  comparison  upon  the  sheet,  thus 
dividing  the  items  into  two  classes,  —  long  term  and  short  term ; 
but,  in  any  case,  the  items  should  be  so  clearly  designated  that 
any  intelligent  reader  of  the  balance  sheet  can  make  the  compari- 
son with  a  fair  degree  of  accuracy.  Illustration  of  this  plan  will 
be  given  in  the  chapter  on  railroad  reports. 


CHARACTERISTICS   OF   THE    BALANCE    SHEET        1 39 

In  this  same  connection  it  is  well  to  bear  in  mind  that  certain 
funds  set  aside  for  specific  purposes  should  be  so  invested  that 
they  may  serve  their  purpose.  For  instance,  a  depreciation  fund 
invested  in  real  estate  in  a  Western  town  that  is  awaiting  a  boom 
is  not  available  to  replace  worn-out  machinery  in  an  Eastern  fac- 
tory. A  depreciation  fund  that  is  somewhere  in  an  unavailable 
form  is  in  one  sense  no  depreciation  fund  at  all. 

This  matter  of  the  availabihty  of  funds  as  "quick  assets"  has 
another  interesting  bearing.  Suppose  the  balance  sheet  of  a  cor- 
poration shows  a  profit  that  justifies  a  6%  dividend,  we  will  say 
$60,000.  The  assets  are  as  follows:  certain  real  estate,  valued  at 
the  city  assessor's  figure,  which  we  assume  in  this  case  to  be  con- 
servative; some  bills  receivable,  of  which  none  will  become  due 
in  less  than  three  months,  but  all  known  to  be  good;  machinery 
and  merchandise  on  hand,  both  valued  conservatively;  and  $5000 
in  cash.  Should  this  corporation  declare  a  dividend?  Th^  books 
show  available  profit  of  $60,000,  and  yet  there  is  but  $5000  in  cash 
on  hand.  Has  the  corporation  earned  a  dividend?  Comparing 
resources  and  liabilities  we  find  that  it  seems  to  have  done  so,  be- 
cause its  resources  are  $60,000  in  excess  of  its  liabiHties ;  but  where 
are  those  profits?  They  must  be  somewhere  in  the  business;  but 
the  only  possibility  of  distributing  them  is  by  borrowing  to  make 
the  dividend  payment.  Would  it  be  right  to  borrow  money  to  pay 
dividends?  There  is  a  very  strong  feeling  in  most  communities 
that  to  borrow  money  for  such  a  purpose  is  always  objectionable. 
A  part  of  that  feeling  is  mere  prejudice.  The  fact  of  borrowing 
to  pay  dividends  is  in  itself  suspicious ;  but  here,  as  in  many  fields, 
a  suspicious  fact  is  by  no  means  indicative  of  bad  morals  or  even 
bad  policy.  If  the  business  management  has  actually  on  hand  the 
assets  reported,  and  if  the  liabilities  are  no  greater  than  are  re- 
ported, there  is  no  objection  to  paying  dividends  by  any  method 
that  shall  prove  feasible.  The  fact  is  simply  that  the  profits  earned 
have  been  invested  in  the  business  as  they  have  come  in;  and 
hence  they  are  not  now  available  for  dividends.  If,  instead  of  fol- 
lowing this  policy,  the  corporation  had  borrowed  money  to  make 
improvements  or  new  investments,  no  one  would  have  thought 
of  criticising  harshly.  Then  the  payment  of  dividends  at  the  end 
of  the  year  would  have  been  taken  as  a  matter  of  course.  The  only 


140  ACCOUNTS 

difference  between  that  policy  and  the  one  actually  adopted  is  that 
the  company  in  the  latter  case  has  saved  interest  from  the  time 
when  the  borrowing  would  otherwise  have  become  necessary.  In 
other  words,  if  it  would  have  been  right  for  the  corporation  to  bor- 
row money  to  make  investments,  it  is  now  right  for  it  to  borrow 
money  to  take  up  those  investments,  so  to  speak,  and  free  the  profits 
which  were  temporarily  locked  up.  It  is  still  true,  however,  that 
borrowing  to  pay  dividends  is  to  be  looked  upon  with  suspicion  until 
one  is  sure,  as  we  are  in  this  case,  that  the  profits  were  actually 
earned. 

A  device  to  avoid  borrowing  to  pay  dividends  is  the  issuing  of 
a  scrip  dividend.  In  this  case  certificates  are  issued  stating  that 
when  presented  in  sufficient  quantities,  for  instance,  multiples  of 
$100,  they  will  be  redeemed  in  new  stock.  What  has  happened, 
then,  is  that  instead  of  paying  cash,  the  corporation  has  increased 
its  amount  of  capital  stock  outstanding.  There  is  commonly  a 
cry  against  this  sort  of  proceeding;  but  here,  as  in  the  last  case, 
if  the  profits  have  been  really  earned  there  is  no  real  ground  for 
objection.  No  one  can  deny  that  if  the  corporation  has  earned 
profits  that  are  in  the  form  of  ready  cash  it  may  distribute  them. 
How  far  different  is  the  case  when,  instead  of  saving  the  cash  until 
the  end  of  the  year  and  distributing  it  to  stockholders,  who  may 
pay  it  back  into  the  corporation  in  payment  for  new  capital  stock, 
the  cash  is  invested  in  the  course  of  the  year  by  the  corporation  and 
at  the  end  of  the  year  new  stock  is  issued  to  the  stockholders  for 
the  same  sum  ?  There  is  absolutely  no  difference  in  the  two  cases 
except  in  the  names  that  are  given  to  the  different  transactions,  — 
unless  in  the  first  case  subscription  to  new  stock  is  voluntary  and 
in  the  other  compulsory.  Clearly  no  stock- watering  is  here,  for  no 
water  enters  into  the  transaction.  Always,  however,  before  this 
process  is  undertaken,  a  corporation  should  consider  the  legal  cir- 
cumstances of  the  case ;  for  many  States,  to  protect  investors  against 
objectionable  issues  of  scrip  dividends  and  loans  to  pay  unearned 
cash  dividends,  have  provided  very  elaborate  regulations  and  re- 
strictions for  all  distributions  except  of  cash  profits.  It  is  neces- 
sary to  realize,  however,  that  there  are  innocent  as  well  as  noxious 
ways  of  paying  dividends  without  available  cash  resources. 


CHAPTER  TEN 

THE  GENERAL   PRINCIPLES   OF    COST  ACCOUNTING 

The  discussion  of  the  last  three  chapters  has  indicated  some  of  the 
problems  that  accounting  has  to  solve.  We  see  by  it  that  though 
the  bookkeeping  may  be  absolutely  correct,  that  is,  may  produce 
correct  balances  and  proper  correspondence  of  debits  and  credits, 
unless  good  judgment  is  used  in  determining  to  what  accounts  items 
should  be  debited  or  credited  and  how  the  debits  and  credits  should 
be  interpreted,  the  results  will  be  misleading  or  at  least  uncertain. 
We  may  now,  having  seen  the  sort  of  thing  that  we  need,  begin  at  the 
other  end  of  the  line  and  see  by  what  processes  we  may  get  it.  It  is 
noteworthy  that  up  to  this  point  we  have  been  concerned  only  with 
the  value  of  resources  and  the  amount  of  profits.  Practically  as  im- 
portant, however,  is  the  question  of  the  comparative  productiveness 
of  different  sources  of  profit  and  the  comparative  expense  of  differ- 
ent methods  or  processes  or  services.  We  have  still,  therefore,  to 
discover  the  general  principles  underlying  the  record  of  earnings  and 
of  cost. 

The  first  problem  in  constructing  a  system  of  accounts  is  always 
this,  —  what  separation  shall  be  made  between  different  sorts  of 
revenue  and  different  items  of  cost?  The  fundamental  principle 
may  be  well  exemplified  by  a  very  simple  illustration,  of  a  sort 
familiar  to  every  one. 

Suppose  you  are  the  owner  of  a  sawmill,  turning  out  nothing  but 
boards  with  the  by-products  of  edgings,  slabs,  and  sawdust.  Every 
revolution  of  the  saw  brings  sawdust,  edgings  or  slabs,  and  boards. 
If  you  keep  no  account  of  any  cost  except  labor,  fuel,  and  general 
expenses,  and  if  you  keep  no  account  of  receipts  except  the  miscel- 
laneous account  of  merchandise,  you  are  far  from  knowing  whether 
every  part  of  your  business  is  paying  what  it  should.  For  example, 
the  question  must  arise  very  soon  in  the  operation  of  the  mill  whether 
it  is  better  to  sell  the  edgings,  to  dump  them  into  the  stream  —  pro- 
vided you  are  not  likely  to  get  into  difficulty  with  riparian  owners,  — 


142  ACCOUNTS 

to  burn  them  in  a  waste  heap,  or  to  burn  them  as  a  part  of  the  fuel 
of  the  mill.  If  they  are  to  be  sold,  they  must  be  piled  and  possibly 
bundled,  and  then  either  shipped  to  the  market  or  sold  on  the  spot. 
Taking  your  mill  as  a  whole,  the  general  costs  are  returned  by  the 
general  receipts,  and  it  is  impossible  to  say  —  just  as  it  is  impossible 
to  say  which  half  of  a  pair  of  scissors  does  the  cutting  —  what  exact 
share  of  the  general  cost  should  be  borne  by  each  part  of  the  general 
product;  but  in  this  matter  of  bundling  edgings,  the  cost  pertains 
to  the  sale  of  edgings  alone,  and  if  you  are  to  sell  your  edgings  you 
must  get  at  least  enough  to  pay  for  that  expense.  If  you  do  not  know 
what  that  expense  is,  you  do  not  know  whether  you  are  actually 
losing  money  in  the  sale  of  edgings  beyond  what  it  would  cost  you  to 
throw  them  away  or  to  burn  them.  Even  in  burning,  there  is  prob- 
ably some  cost  which  would  not  be  suffered  if  they  were  thrown  into 
the  water.  The  same  thing  is  true  of  slabs.  There  are  certain  costs 
connected  with  piHng  and  shipping  that  do  not  belong  in  any  way 
with  the  cost  of  producing  lumber ;  and  therefore  this  cost  must  be 
kept  distinct  or  you  will  not  know  your  profit,  —  indeed,  will  not 
know  whether  you  make  any  profit.  So  much  for  the  simplest  items 
of  cost. 

The  same  applies  to  keeping  record  of  the  receipts.  If  the  price 
of  edgings  bundled  is  fixed  at  such  a  point  in  one  year  that  the  sup- 
ply is  not  wholly  carried  off,  it  is  desirable  to  fix  a  new  price  in  the 
next  year  such  that  the  supply  will  be  taken  off  your  hands.  This 
price,  however,  must  bear  relation  to  the  costs,  and  you  must  know 
at  the  end  of  the  year  whether  the  total  receipts  have  met  the  total 
costs  for  that  particular  part  of  the  product.  Unless,  too,  the  figures 
will  show  the  effect  of  different  prices  upon  the  total  demand,  you 
never  have  a  scientific  basis  on  which  to  work  for  the  future.  Con- 
sequently, receipts  from  the  sales  of  edgings  should  be  kept  as  dis- 
tinct from  other  receipts  as  should  the  cost  of  bundling  edgings  from 
other  costs. 

To  summarize  this  matter,  every  cost  which  can  be  differentiated 
from  other  costs,  and  every  receipt  which  can  be  differentiated  from 
other  receipts,  should  be  so  treated.  Then  it  is  possible  to  judge 
whether  the  cost  is  worth  while,  and  whether  the  price  must  be 
regulated  on  a  new  basis. 

The  general  principles  of  cost- keeping  can  be  illustrated  better, 


GENERAL   PRINCIPLES  OF  COST  ACCOUNTING       1 43 

perhaps,  from  the  reports  of  railroads  than  in  any  other  way.  The 
railroad  accounts  of  the  country  are  better  kept,  probably,  than  ac- 
counts of  any  other  sort,  —  in  spite  of  the  fact  that  there  is  a  general 
complaint  that  they  are  not  kept  better  than  they  now  are.  Even 
before  the  Interstate  Commerce  Commission  was  established,  there 
had  been  a  movement  among  railroad  accountants  and  state  rail- 
road commissioners  to  bring  about  a  certain  uniformity  in  railroad 
accounts.  The  progress  had  not  been  very  great,  however,  before 
the  Interstate  Commerce  Commission  was  by  law  required  to  pre- 
scribe to  the  railroads  the  form  in  which  their  operations  should 
be  reported  to  that  body.  This  form  required  by  the  commission  is 
now  the  standard,  and  furnishes  us  many  illustrations  of  the  prin- 
ciples that  should  be  applied  to  cost  accounting.  Not  only  the  pres- 
ent requirement  but  the  development  of  that  requirement  is  in- 
teresting. 

The  operating  expenses  of  railroads,  as  distinguished  from  other 
costs  such  as  interest,  taxes,  etc.,  had  been  until  lately  di\'ided  by 
the  Interstate  Commerce  Commission  into  four  groups,  —  main- 
tenance of  way  and  structures,  maintenance  of  equipment,  conduct- 
ing transportation,  general  expenses.  Each  of  these  groups  covered 
several  accounts :  the  maintenance  of  way  group  had  ten ;  the  main- 
tenance of  equipment,  nine;  conducting  transportation,  twenty- 
seven;  and  general  expenses,  seven.  By  most  of  the  railroads, 
moreover,  these  accounts  prescribed  by  the  Interstate  Commerce 
Commission  have  long  been  subdivided  so  that  some  of  the  large 
railroads  have  more  than  two  himdred  accounts  of  operating  ex- 
penses kept  entirely  distinct  from  each  other,  yet  so  arranged  that 
they  may  be  combined  to  produce  the  figures  required  by  the  In- 
terstate Commerce  Commission.. 

The  purpose  of  this  classification  into  four  groups  is  obvious. 
There  are  three  distinct  kinds  of  railroad  operating  expenses, — 
the  road,  the  rolling  stock,  and  train  movement.  Maintenance  of 
Way  covers  the  road.  Maintenance  of  Equipment  covers  the  rolling 
stock,  Conducting  Transportation  covers  train  movement,  and 
General  Expenses  covers  the  indivisible  expense  pertaining  to  them 
in  common.  To  put  this  in  another  way,  if  all  trains  were  stopped, 
the  group  called  Conducting  Transportation  would  disappear.  If 
all  equipment  were  disposed  of.  Maintenance  of  Equipment  would 


144  ACCOUNTS 

disappear  and  yet  Maintenance  of  Way  and  General  Expenses  must 
be  continued  if  what  is  left  is  not  to  be  allowed  to  suffer  undue  de- 
preciation. Finally,  the  road  may  be  leased  and  still  much  of  the 
General  Expenses  will  continue,  for  the  financial  side  of  the  road, 
such  as  the  payment  of  interest  on  bonds  outstanding,  of  dividends 
on  stock,  of  taxes,  etc.,  must  be  attended  to. 

On  July  I,  1907,  the  Commission  provided  a  new  classification, 
and  now  requires  that  these  accounts  shall  be  divided  into  five  groups, 
differing  from  those  under  the  old  classification  chiefly  in  the  re- 
moval of  items  arising  in  the  traffic  department,  such  as  traffic 
superintendence,  outside  agencies,  advertising,  etc.,  from  the  group 
called  Conducting  Transportation  to  a  new  group  under  the  name 
of  Traffic  Expenses.  This  change  is  clearly  in  accordance  with  sound 
accounting  principles,  for  the  expense  of  getting  traffic  should  not  be 
confounded  with  the  expense  of  conducting  it.  This  new  classifica- 
tion, moreover,  increases  the  number  of  accounts  in  each  group  so 
as  to  include  as  follows:  Maintenance  of  Way  and  Structures,  27; 
Maintenance  of  Equipment,  29;  Traffic  Expenses,  9;  Transporta- 
tion Expenses,  47;  General  Expenses,  11;  a  total  of  123,  as  com- 
pared with  53  under  the  earlier  plan.  This  provides  accounts  for 
great  detail,  as,  for  instance,  a  separate  account  for  lubricants  for 
yard  locomotives,  and  one  for  damages  for  live  stock  killed  or  in- 
jured while  crossing  or  trespassing  on  the  right  of  way. 

The  classification  of  operating  expenses  into  five  groups  on  the 
common  English  plan,  used  until  recently  somewhat  in  this  country, 
is  interesting  because  it  violates,  to  a  certain  degree,  the  main  prin- 
ciples of  cost  accounting.  This  introduces,  besides  four  groups 
similar  to  those  comprising  the  earlier  Interstate  Commerce  Com- 
mission plan,  a  group  called  Motive  Power,  pertaining  solely  to 
locomotives.  To  this  group  are  carried  items  of  repairs  to  loco- 
motives, fuel,  and  wages  of  enginemen,  etc. ;  it  takes  some  items, 
therefore,  from  Maintenance  of  Equipment  and  others  from  Trans- 
portation Expenses.  This  is  clearly  less  logical  than  the  other,  for 
expenses  for  enginemen  and  for  fuel  and  for  locomotive  repairs  are 
not  essentially  different  in  nature  from  the  expenses  for  conductors 
and  for  illuminating  oil  and  for  car  repairs.  Proper  accounting  is 
based  primarily  on  the  purpose  served,  and  only  secondarily  on  the 
object  with  which  the  expense  chances  to  be  identified:  this  plan 


GENERAL   PRINCIPLES  OF  COST  ACCOUNTING        145 

reverses  the  order,  and  determines  the  chief  groups  by  object  and 
only  the  subdivisions  by  purpose;  for  though  all  the  expenses  in- 
cluded in  the  motive- power  group  are  identified  with  locomotives, 
some  are  for  the  maintenance  of  property  and  others  are  for  the 
momentary  service  of  carrying  particular  bits  of  traffic.  It  is  natural 
enough,  therefore,  that  this  classification  should  have  practically 
disappeared. 

Before  we  go  on  to  discuss  more  in  detail  the  five  required  groups 
of  operating  expenses,  it  is  desirable  to  know  that  operating  expenses 
are  divided  from  another  point  of  view  into  two  classes,  —  first, 
those  dependent  upon  the  mere  conduct  of  traffic,  independent  of 
the  amount  of  it,  and,  second,  those  determined  by  the  amount  of 
traffic.  Examples  of  the  first  sort,  that  is,  expenses  dependent  upon 
operation  but  independent  of  the  amount  of  traffic,  are  station  agents, 
because  an  agent  is  necessary  for  each  station,  even  though  but  one 
train  a  day  is  run,  and  general  officers  who  are  necessary  for  con- 
duct of  traffic,  however  great  or  small.  Examples  of  the  second 
kind,  expenses  dependent  directly  upon  the  amount  of  traffic,  are 
engineers,  firemen,  conductors,  brakemen,  fuel,  oil,  printing,  and 
stationery.  We  have  still  to  indicate  another  class  of  expenses,  hardly 
to  be  called  operating  expenses  and  yet  to  be  met  from  the  income, 
which  are  commonly  called  fixed  charges.  These  are  best  illus- 
trated by  taxes  and  interest  on  debt.  These  three  classes  of  expenses 
—  fixed,  semi-independent,  and  directly  dependent  —  are  not  pe- 
culiar to  railroads.  They  appear  everywhere.  The  fixed  expenses 
are  common,  as  interest,  taxes,  etc.  Of  the  semi-independent,  those 
required  by  the  mere  conduct  of  business,  but  independent  of  its 
amount,  are  superintendents,  watchmen,  office  boys,  etc.,  for  a  busi- 
ness of  $50,000  may  sometimes  grow  to  one  of  $500,000  and  yet 
employ  no  more  persons  of  this  kind  and  pay  no  more  office  rent  or 
expenses  of  commercial  travelers.  Finally,  expenses  of  the  third  class, 
those  dependent  directly  upon  the  amount  of  business,  are  common 
in  all  industries  in  the  form  of  wages,  fuel,  teaming,  etc.  It  is  only 
because  the  distinction  of  classes  is  so  much  more  apparent  in  rail- 
roads than  in  other  lines  of  industry  that  we  seldom  hear  of  it  any- 
where else.  All  this  is  important  from  the  point  of  view  of  account- 
ing because  it  throws  light  upon  the  question  of  what  accounts  should 
be  kept. 


146  ACCOUNTS 

On  many  classes  of  goods  railroads  are  accustomed  to  charge  what 
is  commonly  said  to  be  "what  the  traffic  will  bear" ;  and  this  means 
not  necessarily  that  the  roads  charge  all  they  dare  to  charge,  but 
simply  that  these  classes  of  goods  are  carried  at  a  lower  rate  than 
others  just  because  they  cannot  stand  their  proportion  of  fixed 
charges,  —  or  even,  perhaps,  of  what  we  have  called  the  semi-in- 
dependent charges.  For  example,  logs  for  lumber  and  for  pulp  are 
so  heavy  and  bulky  that  if  a  rate  were  made  on  them  as  high  as  on 
silks,  no  road  could  get  any  logs  to  carry ;  and,  to  a  certain  extent, 
the  same  thing  appUes  to  lumber,  coal,  ore,  and  grain.  The  road  must 
pay  its  fixed  charges  whether  it  gets  any  freight  or  not ;  and  it  must 
pay  its  station  agents,  telegraph  Unes,  general  officers,  section  gangs, 
etc.,  whether  it  carries  any  of  these  bulky  and  heavy  commodities  or 
not.  Any  rate  of  freight  on  these  bulky  things,  if  it  will  pay  direct 
charges  —  that  is,  the  mere  additional  direct  cost  of  carrying  them 
plus  a  small  margin  of  profit,  —  is  worth  while  if  the  road  can  get 
no  more.  A  freight  transportation  agency  is  carrying  all  the  time 
much  traffic  that  contributes  nothing  towards  fixed  expenses,  and 
little,  if  anything,  toward  the  second  class  of  expenses.  Those  ex- 
penses must  be  covered  by  freight  that  can  afford  to  cover  not  only 
its  own  share  but  the  share  of  other  classes.  This  will  perhaps  be 
more  clear  if  we  recur  to  the  illustration  of  the  edgings  turned  out  as 
a  by-product  from  the  sawmill.  Even  though,  perhaps,  the  edgings 
cannot  be  sold  at  a  price  which  will  help  to  pay  interest  on  the  in- 
vestment and  the  wages  and  fuel  of  running  the  mill,  rather  than 
throw  them  away  one  should  sell  them  at  a  price  which  will  pay  a 
small  profit  on  the  mere  cost  of  bundling.  It  becomes  necessary, 
similarly,  for  a  railroad  to  know  what  is  the  actual  direct  cost  of 
hauling  traffic  independent  of  any  share  in  the  indirect  costs  and 
fixed  charges,  in  order  that  it  may  know  what  is  the  minimum  rate 
at  which  it  can  afford  to  take  traffic  that  can  pay  but  little.  Such 
traffic  will  be  worth  while  if  the  other  traffic  will  pay  fixed  and  semi- 
dependent  charges. 

Now  let  us  see,  by  a  simple  illustration,  how  railroad  charges  are 
distributed  among  the  numerous  accounts.  Suppose  an  engineer 
and  a  fireman  devote  the  morning  to  running  a  train  for  a  construc- 
tion crew  distributing  ties  for  a  strip  of  second  track.  The  Interstate 
Commerce  Commission  has  under  the  group  Transportation  Ex- 


GENERAL  PRINCIPLES  OF  COST  ACCOUNTING        1 47 

penses  an  account  called  Road  Enginemen.  The  wages  of  this 
engineer  and  fireman  seem  to  belong  here ;  but  when  we  realize  that 
the  new  strip  of  track  should  be  charged  to  capital  and  not  to  revenue, 
we  see  that  the  wages  should  go  to  some  account  that  will  be  included 
ultimately  in  the  principal  assets  account  —  Construction,  or  Cost 
of  Road,  as  it  is  more  commonly  called.  We  find  provision  for  this 
in  the  ''Classification  of  Expenditures  for  Road  and  Equipment." 
Under  the  account  entitled  Track  Laying  and  Surfacing,  we  find 
directions  as  follows:  "To  this  account  should  be  charged  the  cost 
of  distributing,  laying,  spacing,  and  lining  ties;  .  .  .  expenses  of 
locomotives,  cars,  and  crews  distributing  track  material." 

Suppose  in  the  afternoon  of  the  same  day  the  same  engineer  and 
fireman  are  running  an  engine  hauling  a  special  train  with  coal  for 
the  company's  use.  Two  important  matters  may  be  misrepresented 
if  an  error  is  made  in  charging  their  wages.  If  the  wages  are  charged 
to  the  natural  account  under  Transportation  Expenses,  that  is, 
Road  Enginemen,  and  no  charge  is  made  to  fuel,  the  cost  of  fuel  is 
understated,  and  by  so  much  the  road  is  likely  to  be  misled  as  to  the 
comparative  economy  of  coal,  coke,  wood,  and  oil ;  again,  since  this 
cost  will  be  included  in  the  general  costs  of  hauling  freight,  the 
comparison  between  costs  and  receipts  from  freight  will  be  mis- 
represented. Either  of  two  methods  of  charging  will  avoid  the  diffi- 
culty; one  is  to  charge  the  wages  for  transportation  of  coal  direct 
to  fuel  account,  the  other  to  charge  them  to  Road  Enginemen  and 
then  charge  fuel  account  for  freight  at  regular  or  reduced  rates. 
It  is  better  accounting  to  represent  facts  exactly,  and  at  no  stage 
to  confuse  revenue  service  with  company  service.  This  is  the  plan 
of  the  Commission. 

If,  the  next  day,  these  enginemen  are  engaged  in  running  an 
engine  to  the  repair  shop  and  trying  out  another  that  has  been 
repaired,  clearly  their  wages  should  be  charged  not  in  the  group 
Transportation  Expenses,  but  in  that  for  Maintenance  of  Equip- 
ment. 

If  on  that  afternoon  they  are  engaged  in  switching  cars  in  the 
yard,  the  charge  should  be  made,  under  Transportation  Expenses, 
to  Yard  Enginemen.  The  Commission's  classification  gives  ten 
accounts  for  yard  expenses.  One  purpose  to  which  these  may  be  put 
is  to  enable  a  manager  to  keep  run  of  the  adequacy  or  inadequacy 


148  ACCOUNTS 

of  switching  facilities.  If  the  tracks  for  making  up  trains  are  insuffi- 
cient in  number,  a  large  waste  is  suffered  in  backing  and  pulling  to 
arrange  cars  in  such  order  that  they  may  be  dropped  easily  at  their 
proper  stations  along  the  way.  Is  land  for  adequate  terminal  yards 
cheaper  than  heavy  switching  expense?  Again,  the  question  is 
likely  to  arise  at  any  time  whether  it  is  cheaper  to  provide  at  a  cer- 
tain station  an  engine  and  a  switching  crew,  or  to  have  the  switching 
done  at  that  station  by  regular  train  crews  who  shall  be  delayed 
long  enough  to  perform  the  switching  for  that  station  while  en 
route. 

Finally,  if  the  enginemen  are  hauling  an  ordinary  freight  train 
on  a  single  track  line  and  are  delayed  so  much  by  waiting  at  sidings 
to  pass  other  trains  that  they  finish  their  day's  work  two  hours  late 
and  must  be  paid  extra  wages  for  that  delay,  the  charge  may  then 
be  made  to  Delayed  Time,  a  subdivision  (under  Road  Enginemen) 
not  provided  by  the  Commission.  This  account  may  serve,  to  a 
certain  extent,  to  measure  the  probable  saving  from  increased 
sidings  and  second,  third,  or  fourth  track  along  the  line.  Even  to 
greater  extent  may  it  be  set  against  the  cost  of  additional  train 
dispatchers  and  telegraph  operators  to  report  train  movement. 

These  various  charges  of  wages  for  enginemen  sufficiently  sug- 
gest that  an  accountant  must  look  far  below  the  surface  in  order 
to  determine  all  elements  of  cost,  for  here  to  the  superficial  observer 
the  men  were  doing  identically  the  same  work  in  all  cases;  and 
yet  the  disposition  of  the  amount  of  their  wages  is  an  important 
element  not  only  in  determining  profits,  but  also  in  the  statistics  by 
which  the  manager  must  determine  his  policy.  In  four  of  the  five 
cases  the  charge  comes  out  of  revenue,  and  hence  profits  would  not 
be  affected  if  the  wages  were  carried  to  any  one  of  these  accounts 
rather  than  to  another ;  but  any  confusion  would  have  hidden  costs 
in  conducting  different  parts  of  a  railroad's  service.  In  the  first 
case,  however,  since  charging  to  the  natural  account  would  have 
been  to  revenue,  whereas  the  charge  properly  should  have  been 
to  capital,  it  would  have  understated  both  the  profits  and  the  re- 
sources of  the  road. 

Let  us  now  take  up  the  same  sort  of  thing  from  a  slightly  different 
point  of  view.  We  have  considered  some  accounts  and  what  they 
stand  for.  Let  us  now  take  a  simple  case  of  exercise  of  judgment  by 


GENERAL  PRINCIPLES   OF  COST  ACCOUNTING         1 49 

the  manager,  and,  as  a  hint  of  what  accounts  must  be  kept,  see  what 
information  he  desires  to  get.  Mr.  J.  Shirley  Eaton,  in  his  book 
entitled  "Railroad  Operations:  How  to  Know  Them,"  uses  for 
illustration  of  one  of  his  points  the  question  of  the  best  way  to  get 
a  particular  bit  of  passenger  traffic.  Is  it  better  economy  to  run 
a  passenger  train,  to  add  a  passenger  coach  or  two  to  a  freight  train 
(making  what  is  called  a  mixed  train),  or  to  give  up  altogether  the 
attempt  to  get  the  traffic  ?  Let  us  use  his  illustration,  adding  a  few 
elements  for  our  particular  purpose  here. 

The  first  question,  of  course,  is  as  to  the  cost  of  the  passenger 
train,  which  will  be  the  maximum  cost  of  carrying  the  traffic.  This 
can  be  estimated  fairly  well  from  the  figures  of  cost  of  fuel,  engine- 
men,  train  service,  maintenance  of  equipment,  etc.,  with  a  few  extra 
costs  that  may  be  involved  in  the  service  of  gate-keepers,  ticket- 
sellers,  etc.,  for  that  particular  train;  for  sometimes  a  train  goes 
along  at  such  a  time  of  day  that  it  involves  extra  hours  or  extra 
help  for  service  along  the  road.  Next  we  have  to  estimate  the  addi- 
tional revenue  from  that  particular  train ;  and  by  this  we  mean  not 
merely  the  earnings  of  that  train,  but  the  earnings  of  that  train  that 
the  other  regular  trains  could  not  get.  For  example,  without  such 
train  it  is  possible  that  some  of  the  traffic  would  be  picked  up  by 
later  or  earlier  trains  if  this  one  were  not  sent  out.  On  the  other 
hand,  however,  the  revenue  from  a  train  may  be  greater  than  the 
earnings  from  that  particular  train.  Some  trains  which  are  run  at 
an  apparent  loss  are  continued  because  they  make  suburban  towns 
possible  for  residence  to  people  who,  though  they  seldom  use  those 
trains,  would  refuse  to  live  in  the  country  at  all  if  transportation 
were  not  available  whenever  their  need  may  arise.  Such  trains, 
therefore,  though  they  be  usually  almost  empty,  secure  large  sub- 
urban traffic  both  morning  and  afternoon. 

We  have  now  seen  means  of  determining  or  estimating  the  cost 
of  the  passenger  train  and  the  probable  revenue ;  and  we  have  still 
to  determine  what  would  be  the  cost  and  probable  revenue  of  the 
additional  passenger  coach  or  two  on  a  freight  train.  The  actual 
additional  direct  cost  of  the  passenger  car  or  two  cannot  be  large, 
but  some  costs  are  likely  to  be  forgotten.  The  obvious  costs  are 
extra  fuel  and  extra  stationery  (for  reports)  and  Hghts;  but  the 
danger  of  accident  is  greater  on  a  freight  than  on  a  passenger  train. 


ISO  ACCOUNTS 

and  this  means  so  much  greater  cost,  either  direct  or  indirect,  for 
loss  and  damage.  It  is  difficult  to  stop  a  heavy  freight  train  at  any 
exact  given  spot,  so  that  to  stop  a  passenger  car  in  front  of  the 
passenger  platform  involves  more  loss  of  power  (or  fuel),  more 
wear,  especially  on  brake  shoes  (or  more  delay  in  slowing  down 
very  gradually),  or  more  risk  to  passengers  if  they  are  not  set  down 
exactly  at  the  station.  This  last  danger,  which  seems  very  trivial, 
is  so  great  that  most  railroads  refuse  to  sell  tickets  for  stations  at 
which  trains  are  not  advertised  to  stop,  even  though  the  trains  are 
sure  to  stop  near  the  station  for  water  or  for  a  grade  crossing :  rail- 
roads are  Hable  for  damages  for  a  sprained  ankle  or  other  injuries 
if  a  passenger  is  not  given  a  safe  place  to  alight.  Finally,  it  must 
be  realized  that  the  revenue  from  the  mixed  train  is  likely  to  be 
less  than  from  a  passenger  train.  It  furnishes  a  less  desirable  mode 
of  travel,  enables  a  road  to  compete  less  well  with  other  roads  at 
competing  points,  and,  since  the  conductor  is  occupied  in  looking 
after  his  freight,  is  less  likely  to  yield  correct  fares.  Only  when  all 
these  things  have  been  considered  is  the  general  manager  in  a  posi- 
tion properly  to  determine  whether  such  a  train  should  be  run  or 
not.  It  is  not  true,  of  course,  that  in  every  case  careful  figuring  of 
exactly  these  items  is  done,  for  a  general  manager  from  long  experi- 
ence has  acquired  a  general  knowledge  which  enables  him  to  give 
quick  judgment ;  but  this  experience  upon  which  he  bases  his  judg- 
ment was  acquired  originally  through  statistics  derived  from  care- 
ful accounting. 

It  should  be  obvious,  from  these  illustrations,  that  good  account- 
ing will  distinguish  and  preserve  as  far  as  possible  both  the  cost  and 
the  return  of  every  product  and  of  every  service;  for  only  thus  can 
a  manager  know  what  sort  of  business  he  is  really  doing. 


CHAPTER  ELEVEN 

THE    PLACE    OF    STATISTICS   IN    ACCOUNTING 

It  must  not  be  thought  that  accounting  is  always  a  matter  of  dollars 
and  cents  or  of  debit  and  credit  figures.  Many  essential  figures 
of  accounting  are  not  susceptible  of  translation  into  those  terms; 
they  are  nothing  but  statistics  preserved  for  business  purposes. 

Here,  as  in  so  many  other  cases,  we  can  best  illustrate  the  prin- 
ciples by  recurring  to  railroad  figures,  for  every  one  is  familiar  with 
the  simpler  facts  of  railroad  operation,  and  railroad  reports  are 
almost  the  only  full  reports  accessible  for  the  average  man's  study. 
Some  railroads  furnish  more  than  one  hundred  items  of  statistical 
information,  and  most  of  these  are  combinations  of  figures  not 
published,  which  show  much  more  detail  for  the  use  of  the  officers 
of  the  road.  Some  indication  of  these  is  likely  to  be  well  worth 
while. 

Though  no  two  statistical  reports  of  railroads  are  alike,  many 
items  are  common  to  all  (perhaps  given  under  different  names)  and 
many  may  be  combined  so  as  to  produce  results  that  may  be  com- 
pared for  different  roads.  These  statistics  may  be  divided  into  four 
sections  —  passenger  traffic,  freight  traffic,  loading  statistics,  and 
cost  statistics,  —  though  they  are  not  usually  arranged  in  this  way 
by  the  roads  publishing  them. 

One  of  the  first  questions  which  any  one  asks  himself  about  a 
railroad  report  in  which  he  is  interested  is.  Have  the  earnings  been 
earned,  or  are  they  represented  as  greater  or  less  than  the  facts 
warrant?  Obviously,  one  of  the  first  minor  questions  to  consider 
in  answering  this  main  question  is  whether  charges  have  been  made 
to  capital  that  should  have  been  made  to  maintenance.  Suppose  the 
report  shows  that  a  certain  number  of  cars  have  been  purchased 
during  the  year  and  charged  to  equipment.  At  once  the  question 
arises  whether  the  cars  reported  last  year  as  on  hand  have  been 
thoroughly  utilized,  and,  therefore,  whether  the  new  cars  were 
necessary.    It  is  possible  to  learn  from  statistics  of  various  roads 


152  ACCOUNTS 

what  is  the  average  mileage  of  freight  cars  per  year.  In  sections  of 
the  country  where  hauls  are  long,  the  average  will  be  higher  than 
where  they  are  short,  for  loading  and  unloading  will  consume  less 
time.  If  the  report  gives  among  the  statistics,  as  it  should,  the 
number  of  freight  cars  and  the  total  number  of  freight-car  miles, 
it  is  possible,  by  a  bit  of  figuring,  to  determine  the  average  mileage 
per  car.  If  this  is  considerably  less  than  the  average  for  other  roads 
similarly  situated,  say  ten  thousand  instead  of  twelve  thousand, 
obviously  either  the  cars  are  not  being  utilized  and  therefore  new 
ones  are  not  necessary,  or  the  cars  reported  as  among  equipment 
a  year  ago  were  in  such  poor  condition  that  the  road  did  not  dare 
to  run  them,  but  had  them  shunted  off  on  side  tracks  to  go  to  decay. 
In  the  first  of  these  cases,  the  purchase  of  new  cars  was  an  un- 
necessary locking  up  of  capital;  in  the  second,  it  was  a  charge  to 
equipment  that  should  have  been  made  to  maintenance. 

Other  comparisons  will  assist  one  to  form  a  judgment  on  the  same 
question.  Under  normal  conditions  the  cost  of  repairs  per  freight 
car  should  be  about  sixty  dollars  per  year.  If  we  know  the  equip- 
ment, we  can  easily  determine  about  what  should  be  the  figure 
of  maintenance  for  that  one  item.  Again,  freight-car  repairs  are 
normally  about  six  mills  per  mile  run.  If  we  know  the  figure  of  car 
miles  we  can  make  an  estimate  on  this  basis.  Similarly,  figures  are 
attainable  for  locomotive  repairs  (about  seven  cents)  and  for  passen- 
ger-car repairs  (about  one  cent).  All  such  figures  vary,  however,  in 
dififerent  parts  of  the  country. 

Maintenance  of  way  can  be  properly  judged  only  when  we  know 
how  many  new  ties  and  new  rails  have  been  laid ;  most  roads  re- 
port them.  Since  rails  last  about  eighteen  years,  and  ties  about 
seven,  the  average  requirement  for  replacement  may  be  easily  fig- 
ured. 

It  is  often  desirable  to  consider  the  comparative  operating  ex- 
pense of  two  roads,  sometimes  when  they  are  of  similar  standard 
and  sometimes  when  of  very  different  standards.  This  is  obviously 
of  no  benefit  unless  we  can  get  some  information  about  the  operat- 
ing details  of  each  road,  —  for  example,  in  such  a  matter  as  load- 
ing, for  this  is  one  of  the  important  criteria  of  economy  of  railroad 
operation.  It  is  obvious  that  if  the  cars  are  not  loaded  to  their  ca- 
pacity an  unnecessary  number  are  hauled  over  the  road,  requiring 


THE   PLACE  OF  STATISTICS  IN  ACCOUNTING         1 53 

extra  fuel,  extra  train  hands,  extra  wear  and  tear  not  only  on  the 
cars  themselves  but  also  on  the  roadbed,  and  an  actually  greater 
number  of  locomotives  to  do  the  hauling.  The  same  thing  will 
apply  to  the  making  up  of  trains,  for  to  give  a  locomotive  a  smaller 
number  of  cars  than  it  can  economically  haul  is  the  same  sort  of 
evil  as  to  give  a  car  a  small  freight. 

Often  it  is  desirable  to  compare  the  operations  of  the  road  for  one 
year  with  those  for  another  year.  If  the  earnings  have  fallen  off,  one 
naturally  desires  to  know  whether  that  reduction  has  been  due  to  a 
reduction  of  rates,  to  a  falling  off  in  traffic,  to  an  increase  in  ex- 
penses, or  to  a  change  in  the  character  of  traffic.  Some  roads,  after 
carrying  for  a  great  many  years  traffic  of  a  particular  type,  have 
found  themselves,  because  of  changes  in  their  relations  with  other 
roads  or  of  changes  in  industrial  conditions,  carriers  chiefly  of  other 
kinds  of  goods.  It  is  naturally  a  matter  of  time  before  accommo- 
dation to  the  new  conditions  is  complete;  changes  in  rates  or  in 
equipment  may  be  required,  but  in  any  case  a  change  in  traffic  is 
likely  to  produce  a  considerable  change  in  gross  and  possibly  in 
net  earnings. 

We  may  now  take  in  detail  some  of  the  more  common  statistical 
figures  reported.  For  passengers,  a  report  should  cover  under  the 
head  of  "number  of  passengers  carried  "  the  number  of  trips  made 
by  passengers.  The  ''passenger  miles"  should  show  the  sum 
total  mileage  of  all  passenger  trips.  The  latter  divided  by  the  former 
gives  the  average  number  of  miles  for  each  passenger.  These  figures 
enable  us  to  compare  traffic  of  different  years  and  of  different  roads. 
Then,  for  passenger  earnings,  we  have  the  average  paid  by  each 
passenger,  the  average  rate  per  mile,  the  passenger  earnings  per 
mile  of  road  (the  total  passenger  earnings  of  the  road  divided  by 
miles  of  road  so  as  to  show  something  of  the  density  of  passenger 
traffic),  and  the  passenger  earnings  per  train  mile  (indicating  the 
average  earnings  from  passengers  for  every  mile  traveled  by  a 
passenger  train).  The  operation  of  passenger  trains  is  indicated  by 
such  statistics  as  the  following:  passenger-train  mileage;  passenger- 
car  mileage;  the  average  number  of  passenger  cars  in  a  passenger 
train;  the  average  number  of  passengers  per  train;  the  average 
number  of  passengers  per  car;  locomotive  mileage  assisting  pas- 
senger trains.  It  is  obvious  that  the  figures  for  number  of  passengers 


154  ACCOUNTS 

in  a  train  and  in  a  car  furnish  some  means  of  judging  whether  the 
accommodation  furnished  by  the  road  is  better  than  the  conditions 
of  traffic  warrant.  Unless  a  road  is  distinctly  engaged  in  a  competi- 
tive war  or  in  building  up  the  country  which  it  traverses,  its  average 
number  of  passengers  per  train  should  not  be  far  below  the  average 
for  its  class. 

The  same  sort  of  principles  is  applied  usually  in  freight  statis- 
tics ;  but,  from  the  nature  of  the  case,  they  must  be  carried  somewhat 
more  into  detail,  since  in  the  matter  of  freight  the  unit  is  not  a  single 
mile,  and  must  include  also  the  number  of  tons  and  the  kind  of  goods 
transported.  The  chief  freight  statistics  are  as  follows :  tons  hauled ; 
ton  miles  (that  is,  the  number  of  tons  of  each  shipment  multiplied 
by  the  number  of  miles  it  was  hauled) ;  average  receipts  per  ton 
mile ;  average  earnings  per  train  mile ;  average  earnings  per  mile  of 
road;  the  number  of  tons  transported  of  various  kinds  of  staple 
goods.  Some  railroads  report  the  tons  of  as  many  as  fifty  kinds  of 
staple  goods.  This  figure  is  obviously  a  benefit  in  enabling  one  to 
make  a  comparison  between  different  roads  and  different  years  on 
the  same  road. 

When  we  come  to  the  conduct  of  this  freight  traffic,  we  find  the 
freight- train  miles,  the  car  miles,  the  average  number  of  cars  in  a 
train,  and  the  average  number  of  tons  in  a  car,  to  be  essential  fig- 
ures. Most  roads  do  not  adequately  report  their  loading  by  direc- 
tions. A  little  consideration  will  show  that  this  is  a  matter  of  great 
importance.  If  the  bulk  of  traffic  is  eastward,  as  it  usually  is,  since 
crude  products  have  their  origin  chiefly  in  the  West,  obviously  the 
loading  in  the  eastward  direction  should  be  the  maximum,  because, 
since  the  goods  transported  westward  must  be  of  a  kind  to  occupy 
less  space  in  the  cars  than  that  coming  in  the  other  direction,  every 
ton  of  weight  in  cars  and  locomotives  not  properly  utilized  on  an 
eastward-bound  train  must  be  dead  weight  on  a  corresponding  west- 
ward trip.  In  spite  of  this  requirement  for  the  heavy  loading  east- 
ward, however,  since  traffic  does  not  distribute  itself  always  in 
such  a  way  that  empty  cars  shall  always  be  available  at  the  points 
where  wanted  for  the  purpose  of  loading,  it  sometimes  becomes 
necessary,  in  order  to  supply  shippers  with  empty  cars,  to  run  cars 
from  the  nearest  station  where  they  may  happen  to  be,  and  that  may 
require  eastward  movement,  so  that  a  certain,  but  comparatively 


THE  PLACE  OF  STATISTICS  IN  ACCOUNTING         1 55 

small,  empty-car  mileage  even  in  the  eastward  direction  may  prove 
necessary.  To  show  that  this  is  not  excessive,  a  report  should  dis- 
tinguish between  loaded  cars  eastward  and  empty  cars  eastward. 
This  enables  us  to  judge  at  once  whether  presumably  the  best 
loading  has  been  maintained.  When  we  come  to  westward  move- 
ment, on  the  other  hand,  the  loading  per  car  is  of  very  slight  con- 
sequence ;  for  since,  at  best,  many  cars  must  go  westward  empty, 
whether  the  cars  are  loaded  to  the  maximum  capacity  or  not  is  a 
matter  of  indifference.  The  same  thing  is  true  of  average  load  of 
loaded  cars:  we  need  to  know  the  average  load  of  loaded  cars  in 
the  direction  of  heaviest  traffic.  Our  real  requirements  are,  there- 
fore: first,  the  average  number  of  cars  in  all  trains;  second,  the 
average  number  of  loaded  cars  in  a  train  in  each  direction ;  third, 
the  average  number  of  empty  cars  in  a  train  in  each  direction; 
fourth,  the  average  number  of  tons  of  freight  per  loaded  car  in  each 
direction.  In  judging  comparative  loading  of  different  roads,  allow- 
ance should  be  made  for  the  class  of  traffic.  Coal,  for  instance, 
stows  well,  and  the  loading  of  it  should  be  limited  only  by  the  num- 
ber of  tons  a  car  can  support;  but  furniture  stows  badly,  and  for 
it  the  full  capacity  of  a  car  may  be  far  below  the  tonnage  capacity. 
Hence  a  road  getting  the  bulk  of  its  traffic  from  the  furniture  dis- 
trict of  Michigan  would  show  a  lighter  loading  than  one  operating  in 
the  mining  district  of  Pennsylvania. 

Many  roads  divide  their  freight  into  classes  according  to  its  origin ; 
that  is,  the  freight  originating  on  the  company's  own  line  is  dis- 
tinguished from  that  originating  with  other  roads  and  hence  consti- 
tuting through  traffic.  Again,  roads  must  distinguish  between  com- 
pany freight,  so  called,  and  revenue  freight,  —  that  is,  between 
freight  hauled  for  the  road's  own  use  and  freight  hauled  for  revenue. 
Often  this  is  a  matter  of  considerable  importance,  because  the  situ- 
ation of  the  road  may  be  such  that  its  company  hauling  is  a  notable 
percentage  of  its  total  traffic. 

It  is  obvious,  from  the  figures  already  given,  that  much  can  be 
determined  about  the  average  daily  movement  of  cars.  Some  roads, 
on  the  other  hand,  report  elaborately  mileage  of  freight  cars  not  only 
on  their  own  roads  but  also  on  foreign  roads,  including  such  things 
as  the  number  of  days  home  cars  are  at  home,  and  the  number  of 
days  home  cars  are  on  foreign  lines,  and  the  number  of  days  foreign 


156  ACCOUNTS 

cars  are  on  the  home  line.  Sometimes  these  statistics  are  very  ser- 
viceable in  enabling  even  an  outsider  to  form  some  judgment  of  the 
management. 

Some  among  many  other  items  cited  are  gross  earnings  per  mile 
of  road ;  operating  expenses  per  mile  of  road ;  average  expenses  per 
freight-train  mile ;  average  expenses  per  passenger-train  mile ;  cost 
of  coal  per  freight-train  mile  and  per  passenger-train  mile;  miles 
run  per  ton  of  coal ;  and  cost  of  lubricating  oil  and  waste  per  loco- 
motive mile. 

However  many  items  of  statistics  are  reported,  in  the  records  are 
kept  hundreds  more  for  the  use  of  the  general  manager  and  other 
officers  of  the  road.  For  instance,  a  common  statistical  table  is  what 
is  called  the  locomotive-performance  sheet,  which  on  some  roads 
records  the  performance  daily  of  all  locomotives  upon  the  road,  in- 
cluding the  mileage  traveled,  the  number  of  tons  hauled,  the  con- 
sumption of  coal,  of  oil,  and  of  waste.  This  makes  it  possible  to 
judge  not  only  the  amount  of  work  done  daily  on  the  road,  but 
to  compare  types  and  makes  of  locomotives  and  the  efficiency  of 
engineers.  On  some  roads,  this  work  is  so  carefully  done  that  the 
weight  of  coal  going  into  a  locomotive  is  charged  and  the  weight 
brought  back  is  credited. 

The  determination  of  these  statistics  is  not  so  great  a  task  as  might 
at  first  thought  appear.  For  instance,  every  road  must  keep  a  careful 
account  of  all  tickets  sold  by  every  ticket  agent,  in  order  that  the 
ticket  agent  may  be  held  responsible  for  his  receipts.  With  a  very 
little  additional  labor  it  is  possible  to  figure  the  mileage  on  all  tickets 
sold  and  cash  fares  paid.  This,  with  proper  allowance  for  other 
classes  of  passenger  trips,  furnishes  adequate  statistics  for  passenger 
travel.  Similarly,  all  freight  agents  are  held  responsible  to  report 
shipments  from  and  to  other  stations,  and  a  little  figuring  gives  the 
statistics  on  the  basis  of  the  reports.  It  is  necessary,  for  various 
purposes,  to  keep  run  of  car  movement,  and  from  conductors'  re- 
ports car  mileage  and  train  mileage  are  easily  figured. 

A  striking  illustration  of  the  value  of  statistics  in  factory  account- 
ing has  been  given  by  Mr.  C.  E.  Woods,  in  his  ''  Organizing  a  Fac- 
tory." Mr.  Woods  became  satisfied  that  in  a  certain  shop  the  men 
were  not  performing  all  the  work  that  they  should.  He  constructed 
a  graphic  chart  showing  the  earnings,  per  hour,  for  a  year,  of  men 


THE  PLACE  OF  STATISTICS  IN  ACCOUNTING  1 57 

on  piece  wages.  This  showed  a  steady  increase  to  a  certain  point 
and  then  a  slow  falling  off,  though  there  had  been  some  revivals. 
The  conclusion  drawn  from  this  was  that  the  men  were  deliberately 
restricting  their  product  for  fear  that  their  piece-rate  would  be  cut 
down.  The  method  of  testing  this  theory  was  to  install  upon  the 
engine  an  indicator  showing  how  much  horse  power  was  consumed, 
and  to  record  this  consumption  at  intervals  of  every  fifteen  minutes 
during  the  day.  In  this  particular  case  the  total  horse- power  capacity 
of  the  engine  was  1000.  It  was  found  that  530  horse  power  was 
employed  to  drive  the  transmission  plant  when  no  machines  were 
running,  —  that  is,  to  be  ready  for  operations  to  begin  at  seven 
o'clock  in  the  morning.  After  seven  o'clock  the  amount  of  horse 
power  consumed  in  the  operation  of  the  machines  increased  slowly, 
but  it  w^as  not  until  eight  o'clock  that  the  full  capacity  was  in  use,  — 
indicating  sufficiently  that  some  of  the  men  were  not  really  working 
until  they  had  been  in  the  shop  an  hour.  By  eleven  o'clock  the  con- 
sumption of  horse  power  had  begun  to  decline,  and  at  a  quarter  of 
twelve  it  was  only  two  thirds  of  the  total.  In  the  afternoon  the 
men  were  even  slower  in  reaching  maximum  production ;  although 
the  work  was  resumed  at  one  o'clock,  the  total  horse  power  was  not 
consumed  until  half-past  two,  and  decline  in  consumption  began 
in  considerably  less  than  an  hour  and  a  half.  At  quarter  of  five, 
only  two  thirds  of  the  power  was  in  use.  In  other  words,  of  a  con- 
siderable portion  of  the  labor  and  machinery  of  the  shop,  the  con- 
cern was  getting  no  return  for  four  and  a  half  out  of  nine  working 
hours. 

This  discovery  led  to  a  reorganization  of  affairs,  with  the  result 
—  as  indicated  by  the  consumption  of  horse  power  —  that  an  aver- 
age of  seventy-four  minutes  a  day  for  each  man  of  the  sixteen 
hundred  workmen  was  added  to  the  working  time.  Of  course, 
so  far  as  the  men  v;ere  on  piece-work,  this  did  not  affect  their  wages, 
but  it  did  affect  machine-cost.  Every  piece-work  man  was  wasting 
not  only  his  own  time  but  the  time  of  the  machinery  which  the  com- 
pany was  hiring  him  to  utilize.  For  the  day  men,  however,  the  loss 
was  not  only  on  idle  machines,  but  on  wages.  About  one  half  the 
men,  that  is,  eight  hundred  out  of  sixteen  hundred,  were  employed 
at  day  wages.  The  sa\ing  in  their  wages  alone  amounted  to  about 
$60, GOO  per  year. 


IS8  ACCOUNTS 

The  effect  did  not  stop  here,  however.  Mr.  Woods  was  impressed 
with  the  large  consumption  of  horse  power  when  no  machinery  was 
running.  The  consequence  was  an  examination  and  revolution  of 
the  system  of  power  transmission.  As  a  result  there  was  a  saving 
of  $4000  a  year  in  power-cost. 

Finally,  the  men  being  now  obliged  to  work  as  many  hours  per  day 
as  they  had  been  hired  to  work,  a  new  standard  of  production  was 
established.  It  was  made  evident  that  they  could  produce  very 
much  more  than  they  had  been  producing,  without  working  unduly 
hard,  and  the  piece-rate  was  cut  to  such  a  figure  that,  although  the 
men  earned  as  much  as  before,  there  was  a  saving  of  $26,000  a  year 
due  to  increased  production.  There  was  a  total  saving,  therefore, 
from  these  three  sources  of  $90,000,  without  including  any  saving 
of  idle  machine-cost,  which  must  have  been  a  considerable  addi- 
tional element. 

These  illustrations,  from  railroads  and  from  a  factory,  suffi- 
ciently suggest  the  value  of  statistical  information  and  the  great 
number  of  subjects  about  which  it  may  be  secured.  It  is  almost 
safe  to  say  that  in  good  accounting  no  figure  that  can  be  preserved 
should  be  destroyed.  An  accountant  often  finds  valuable  use  for 
a  figure  that  at  first  seemed  meaningless,  and  information  needed 
immediately  is  often  unattainable  simply  because  some  figure  that 
might  easily  have  been  preserved  has  been  destroyed.  This  does 
not  mean  that  a  counting-house  is  to  be  swamped  under  disor- 
dered details.  A  thing  not  preserved  in  an  orderly  fashion  is  not 
worth  preserving  at  all ;  but  a  little  labor  spent  in  arranging,  label- 
ing, and  filing  old  statistical  material  may  often  prove  a  marvelous 
investment. 


CHAPTER  TWELVE 

THE  RELATION  OF   PRINCIPAL   AND    INTEREST   IN   VALUA- 
TIONS 

An  element  of  great  importance  in  all  valuations  involving  time 
is  interest  or  discount.  Both  interest  and  discount  are  payment 
for  the  use  of  money ;  the  fundamental  distinction  between  them 
is  that  interest  is  a  payment  made  at  the  end  of  a  term  of  borrow- 
ing, and  discount  is  a  deduction  made  from  principal  at  the  be- 
ginning of  a  term  of  borrowing. 

Simple  interest  is  determined  by  multiplying  the  rate  per  year  by 
the  time  in  years  and  multiplying  that  product  by  the  principal 
sum.  That  is,  any  two  sums  of  interest  at  a  particular  rate  will 
vary  exactly  in  proportion  to  the  time  and  the  amount  of  the  prin- 
cipal. The  accumulation  is  purely  by  arithmetical  progression. 
Compound  interest,  on  the  other  hand,  is  interest  in  which  the  in- 
terest earnings  of  one  year  are  allowed  to  accumulate  and  bear 
interest  in  the  second  and  all  subsequent  years.  That  is,  though 
at  simple  interest  $1000  borrowed  for  five  years  at  5%  costs 
just  five  times  as  much  as  for  one  year,  or  $250,  at  compound  in- 
terest $50  is  charged  for  the  first  year,  $52.50  for  the  second  year, 
and  $60.77  for  the  fifth  year,  —  because  the  $50  interest  of  the 
first  year  has  borne  interest  four  years,  the  $50  interest  of  the  second 
year  has  borne  interest  three  years,  and  so  on  until  the  end,  and 
in  the  fifth  year  interest  must  be  paid  on  the  accumulation,  —  so 
that  the  total  interest  is  $276.28,  contrasted  with  $250  of  simple 
interest. 

Several  methods  of  figuring  compound  interest  may  be  used. 
If  the  principal  be  multiplied  by  the  rate,  and  the  principal  be 
added,  the  sum  is  the  amount  of  the  debt  or  other  claim  at  the  end 
of  the  first  period ;  this  is  the  same,  of  course,  for  compound  as  for 
simple  interest,  for  compounding  has  not  yet  begun.  If,  now,  this 
amount  be  again  multiplied  by  the  rate  and  the  amount  at  the  end 
of  the  first  period  be  added,  the  result  is  the  amount  of  the  claim 


l6o  ACCOUNTS 

at  the  end  of  the  second  period.  This  process  may  be  continued 
for  the  full  number  of  periods.  It  is  better  to  think  of  periods  than 
of  years,  for  interest  is  often  to  be  compounded  semiannually  or 
quarterly. 

By  another  process,  the  amount  of  claim  is  figured  directly  with- 
out figuring  the  interest.  Of  course  multiplying  the  principal  by  i 
reproduces  that  principal.  Hence  multiplying  it  by  1.05  gives  the 
amount  of  the  claim  for  one  period  at  five  per  cent.  By  this  method, 
therefore,  the  principal  is  multiplied  by  i  plus  the  rate  expressed 
decimally,  and  that  product  again  multiplied  by  i  plus  the  rate, 
and  the  process  continued  as  many  times  as  the  number  of  periods 
requires. 

Again,  the  rate  (expressed  decimally)  plus  i  may  be  multiplied 
by  itself,  or  raised  to  its  second  power.  This  gives  the  amount  of 
one  dollar  at  the  end  of  the  second  period.  This  may  be  again 
multiplied  by  i  plus  the  rate,  that  product  again  multiplied  by  i 
plus  the  rate,  and  so  on  until  the  number  of  periods  has  been  pro- 
vided for.  This  multiplied  by  the  principal  will  give  the  amount  for 
that  principal  at  the  end  of  the  time ;  for  the  amount  for  one  dollar 
multiplied  by  the  number  of  dollars  in  the  principal  will  give  the 
amount  for  that  principal.  To  express  the  same  thing  in  another  way, 
the  rate  plus  i  may  be  raised  to  the  power  indicated  by  the  number 
of  periods  that  the  claim  has  to  run,  and  this  multiplied  by  the 
principal  will  give  the  amount  for  that  principal. 

The  principal  plus  interest  is  always  technically  known  as  the 
**  amount."  The  amount  minus  the  principal  always  gives  the 
compound  interest,  of  course. 

It  is  obvious  that  if  the  number  of  periods  for  the  compound 
interest  is  very  great,  the  process  becomes  extremely  tedious.  In 
practice,  where  it  has  to  be  done  very  often,  logarithms  are  used 
to  reduce  the  work  to  a  very  few  figures.  By  the  use  of  logarithms 
it  is  possible  to  multiply  or  to  divide  or  to  raise  to  a  power  or  to 
find  a  root  by  only  two  or  three  multiplications  and  divisions.  The 
use  of  logarithms,  however,  involves  a  knowledge  of  mathematical 
principles  which  cannot  always  be  assumed;  and,  therefore,  this 
method  will  not  be  described  here,  though  it  is  included  in  the 
illustrations  given  below. 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS 


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PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 63 

Now  let  us  turn  to  discount.  This,  as  has  been  stated,  is  similar 
to  interest,  though  not  paid  at  the  expiration  of  the  period  of  bor- 
rowing but  taken  out  at  the  beginning.  The  common  discount 
of  the  business  world  is  bank  discount  and  differs  in  nature  from 
theoretical  discount,  or,  as  it  is  called,  true  discount.  A  bank  on 
discounting  a  note  for  $1000  for  sixty  days  at  6%  takes  out  $10 
and  gives  the  proceeds  as  $990;  but  $10  is  the  interest  for  sixty 
days  for  $1000,  whereas  the  bank  loans  only  $990;  and,  conse- 
quently, the  bank  is  taking  out  discount  for  a  larger  sum  than  it 
loans.  The  true  method  of  determining  the  amount  of  discount 
on  $1000  for  sixty  days  is  to  find  what  sum  of  money  invested  for 
sixty  days  will  produce  $1000  at  the  end  of  the  time.  If  the  true 
method  is  follow^ed,  the  man  who  pays  that  note  at  the  end  of  the 
time  ought  to  be  able  by  investing  the  sum  which  he  has  received 
from  the  bank  to  obtain  at  the  end  of  the  time  exactly  enough  to 
take  up  the  note,  —  provided,  of  course,  he  invested  at  the  rate  at 
which  the  bank  discounted.  If,  however,  a  man  invests  his  $990 
at  6%  and  then  at  the  end  of  the  sixty  days  takes  the  amount  to 
the  bank,  he  wdll  find  he  wdll  fail  by  ten  cents  to  take  up  the  note, 
for  the  $990  will  have  earned  but  $9.90  interest.  The  proper  method, 
then,  to  determine  theoretical  discount,  is  first  to  find  what  amount 
$1.00  will  reach  in  the  course  of  two  months.  If,  then,  we  divide 
our  principal,  which  in  this  case  is  $1000,  by  the  amount  which 
$1.00  will  reach  in  sixty  days,  we  shall  find  the  principal  which 
will  be  required  to  amount  to  $1000  at  the  end  of  the  time.  In  sixty 
days,  at  6%,  $1.00  will  earn  i0  interest  (for  6%  per  year  is  clearly 
1%  every  two  months).  Dividing  $1000  by  $1.01  we  get  $990.10, 
which  is  the  true  proceeds  of  $1000  discounted  for  sixty  days. 
Now  if  this  sum  is  invested  at  6%  it  will  in  sixty  days  earn  jo  0  ^^ 
itself,  or  $9.90,  which,  added  to  our  original  $990.10,  produces 
the  Siooo  with  which  we  started.  This  $9.90,  then,  is  the  true  dis- 
count, as  distinguished  from  the  bank  discount  of  $10.00.  In  the 
matter  of  investments  it  is,  of  course,  not  bank  discount  but  true 
discount  with  which  we  are  concerned.  Our  business  is  to  learn 
what  sum  of  money  invested  for  a  certain  time  will  produce  certain 
other  sums. 

Compound  discount  differs  in  principle  from  simple  discount 
practically  as  compound  interest  differs  from  simple  interest.    In 


164  ACCOUNTS 

practically  all  business  transactions  it  is  understood  that  interest 
shall  be  paid  periodically,  usually  annually  or  semiannually;  and, 
therefore,  in  figuring  what  sum  of  money  will  accumulate  to  a  cer- 
tain other  sum  in  the  future,  it  is  assumed  that  interest  is  paid  at 
the  end  of  each  named  period  and  usually  that  that  sum  is  rein- 
vested. Consequently,  we  are  obliged  in  compound  discount  to 
take  each  period  by  itself  and  discount  it  to  determine  the  preced- 
ing period.  For  instance,  if  we  wish  to  learn  what  sum  of  money 
invested  for  five  years,  at  5%  interest  payable  annually,  would 
amount  to  $1000,  we  must  first  learn  what  sum  of  money  will  in 
one  year  amount  to  $1000.  In  one  year  at  5%  $1.00  will  amount 
to  $1.05.  Consequently,  if  we  divide  our  $1000  by  1.05  we  shall 
get  the  amount  which  in  one  year  will  accumulate  to  $1000,  — 
that  is,  $952.38.  Now  we  must  learn  what  amount  invested  for 
one  year  will  produce  $952.38.  We  accordingly  divide  this  latter 
amount  by  1.05,  producing  $907.03.  It  is  obvious  at  this  point 
that  $907.03  invested  for  two  years  will  produce  $1000.  We  now 
continue  our  process  and  divide  our  $907.03  by  1.05,  and  we  get 
$863.84,  which  is  the  sum  that  invested  three  years  will  produce 
$1000.  This,  in  turn,  divided  by  1.05  shows  the  amount  which 
invested  four  years  will  produce  $1000,  or  $822.70.  Finally,  divid- 
ing that  by  1.05  we  find  the  amount  which,  invested  at  the  begin- 
ning of  the  five-year  period,  will,  with  interest  payable  annually  at 
5%,  accumulate  to  $1000  at  the  end  of  the  five  years,  or  $783.53. 

This  amount  is  commonly  called  the  present  worth  of  $1000  at 
5%  payable  in  five  years.  It  is  obvious  that  there  is  another  method 
of  producing  the  same  result.  If,  instead  of  dividing  our  figure  by 
1.05  five  times  in  succession,  we  find  the  amount  which  $1.00  will 
reach  when  invested  for  five  years  at  compound  interest,  we  can 
perform  our  result  with  one  division  instead  of  five;  but  we  have 
previously  had  to  perform  four  multiplications.  Thus,  $1.00  in  one 
year  will  amount  to  $1.05;  in  two  years  it  will  amount  to  $i.io|, 
because  the  $.05  interest  of  the  first  year  will  now  earn  I  of  i0 
interest.  In  three  years  $1.00  will  amount  to  $1.15763,  in  four  years 
to  $1.21551,  in  five  years  to  $1.27628.  Then,  dividing  our  $1000 
by  1.27628  we  get  that  sum  which  invested  for  five  years  at  5% 
will  produce  $1000,  which  is,  as  shown  by  the  other  process,  $783.53. 

It  is  interesting  at  this  point  to  inspect  a  table  which  shall  show 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 65 

US  both  compound  discount  and  compound  interest  for  a  few  years, 
in  order  that  we  may  see  the  relation  between  them.  Let  us  apply, 
on  the  $1000  basis,  the  figures  we  have  just  obtained  for  the  com- 
pound interest  of  $1.00.  Obviously  we  have  but  to  move  our  deci- 
mal point  three  places  to  the  right  in  order  to  increase  the  amount 
for  $1.00  to  the  amount  for  $1000,  for  if  $1.05  is  the  amount  for 
$1.00,  $1050  is  the  amount  for  $1000.  Now,  combining  these  figures, 
—  or  the  amounts  for  $1000  given  in  the  first  two  illustrations  on 
page  161, —  with  the  figures  of  compound  discount  which  we  have 
worked  out,  showing  the  present  worth  of  $1000  for  five  years, 
we  obtain  a  table  as  follows: 


$783-53 

5th  present  worth 

822.70 

4th 

((          « 

863.84 

3d 

((          11 

907.03 

2d 

(<          11 

952.38 

ISt 

11          ti 

1,000.00 

Principal 

1,050.00 

ISt 

amount 

1,102.50 

2d 

(( 

1,157-63 

3d 

<( 

1,215-51 

4th 

(< 

1,276.28 

5th 

(( 

Now,  since  the  relation  between  every  amount  here  mentioned 
and  the  next  lower  one  is  the  relation  of  $1.00  to  $1.05,  every  sum 
here  is  the  amount  at  5%  compound  interest  of  the  preceding  sum 
for  one  year;  and  every  sum  here  is  the  amount  at  5%  compound 
interest  of  the  second  preceding  sum  for  two  years;  and  every  sum 
here  is  the  amount  of  the  third  preceding  sum  for  three  years.  Dis- 
counts can  be  shown  in  the  same  way.  Every  sum  here  is  the  present 
worth  at  5%  of  the  next  lower  sum  for  one  year ;  of  the  second  lower 
sum  for  two  years ;  and  so  on.  In  other  words,  the  relation  is  con- 
stant between  present  worth  and  amount,  and  the  table  may  be  read 
either  upward  or  downward,  beginning  at  any  point,  and  the  present 
worths  and  amounts  will  remain  true. 

In  this  table  are  practically  all  the  mathematical  principles  in- 
volved in  the  treatment  of  investment ;  but  the  appKcation  of  these 
principles  is  not  always  obvious.  Perhaps  the  most  common  form 
in  which  this  principle  must  be  appHed  is  that  of  the  annuity,  which 
though  not  appearing  commonly  under  the  name  of  an  annuity  is 


1 66  ACCOUNTS 

involved  in  practically  all  transactions  of  investment.  Occasionally 
an  annuity  is  issued  as  such,  though  less  commonly  in  this  country 
than  in  England.  An  annuity  may  be  defined  as  a  periodical  pay- 
ment for  a  certain  number  of  years  or  for  the  duration  of  certain 
lives,  involving  no  repayment  of  principal;  and  it  is  called  by  this 
name  even  when  the  period  is  only  a  fraction  of  a  year.  The  peri- 
odic payments  are  supposed  to  include  the  repayment  of  principal 
on  the  installment  plan ;  and,  therefore,  each  payment  covers  both 
interest  and  principal.  For  example,  an  annuity  of  $1000  for  ten 
years  means  that  $1000  shall  be  paid  annually  for  ten  years  and  then 
all  payments  shall  cease,  and  no  charge  on  account  of  principal  shall 
remain.  What  is  such  an  annuity  worth?  At  the  basis  of  such  a 
calculation  must  be  the  market  rate  of  interest  on  long-term  loans 
where  the  security  is  of  this  class,  that  is,  under  similar  conditions  of 
safety.  Of  course,  wherever  the  risk  is  greater  or  less,  a  higher  or  a 
lower  rate  of  interest  must  be  figured ;  and,  therefore,  to  determine 
the  value  of  an  annuity  it  is  necessary  to  use  as  a  basis  a  rate  pre- 
vailing under  similar  conditions  of  security.  If  market  interest  is 
6%,  a  permanent  annuity  of  $6.00  is  clearly  worth  $100,  for  $100 
invested  in  the  market  will  produce  $6.00.  If,  on  the  other  hand, 
interest  in  the  market  is  5%,  a  permanent  annuity  of  $6.co  is  worth 
$1 20,  for  $1 20  is  necessary  when  invested  at  the  market  rate  to  pro- 
duce $6.00  in  interest.  If,  again,  the  market  rate  is  10%,  a  perma- 
nent annuity  of  $6.00  is  worth  only  $60,  for  $60  will  in  the  market 
produce  $6.co  interest.  Let  us  in  this  case  arbitrarily  call  the  rate 
of  interest  in  the  market  on  security  of  this  class  5%.  Our  problem, 
then,  is  this:  What  is  the  present  worth  at  5%  of  $1000  payable  in 
one  year,  of  another  $1000  payable  in  two  years,  of  another  $1000 
payable  in  three  years,  and  so  on  up  to  and  including  a  tenth  $1000 
payable  in  ten  years  ?  That  is  to  say,  for  the  first  $1000  payable  in 
one  year  the  buyer  of  the  annuity  is  obliged  to  wait  one  year ;  for  the 
second  $icoo  he  must  wait  two  years;  for  the  third  $ioco,  three 
years;  and  so  on  until  and  including  the  tenth  $1000,  for  which  he 
must  wait  ten  years.  The  present  worth  of  an  annuity  of  $1000  for 
ten  years,  or,  to  express  it  differently,  the  price  one  must  pay  to-day 
to  secure  that  annuity,  is  the  sum  of  the  present  worths  of  $1000 
payable  at  the  end  of  each  year  of  the  ten.  A  reference  to  the  table 
given  above  shows  the  present  worths  of  $1000  at  5%,  to  be  as 
follows : 


PRINCIPAL  AND   INTEREST  IN   VALUATIONS  1 67 

One  year,  $952.38 

Two  years,  90  7  03 

Three  years,  863.84 

The  total  of  such  figures  for  ten  years,  or  $7721.73,  is  the  figure  we 
are  seeking. 

There  is  also,  of  course,  the  reverse  problem,  that  is,  how  large 
an  annuity  for  ten  years  will  a  certain  sum  of  money  buy,  say  $25,- 
000.  Let  us  find  a  method.  A  sum  paid  now  is  worth,  of  course, 
more  than  a  sum  payable  one  year  in  the  future;  or,  to  express  it 
differently,  one  dollar  payable  in  one  year  will  cost  less  than  one 
dollar  paid  down.  A  sum  considerably  less  than  $1.00  will,  if  in- 
vested to-day  on  the  5%  basis,  produce  at  the  end  of  the  year  $1.00 ; 
or,  to  be  exact,  $.95238  will,  paid  down  to-day,  produce  $1.00  at 
the  end  of  the  year.  Similarly,  $.90703  will,  paid  down  to-day,  in 
two  years  produce  $1 .00 ;  and  in  three  years  $.86384  will  produce 
$1.00.  The  same  process  continued  through  the  ten  years  shows 
how  much  it  is  necessary  to  invest  now  to  produce  $1.00  at  the  end 
of  each  of  the  ten  years.  The  total  of  this  column  of  figures,  or 
$7.721735,  is  the  present  worth  of  the  annuity  of  $1.00  for  ten  years. 
Then  our  $25,000  to  be  invested  divided  by  the  total  which  it 
will  cost  to  buy  an  annuity  for  $1.00  will  show  for  how  many 
dollars  $25,000  will  buy  a  ten-year  annuity  on  the  5%  basis,  — or 
$3237.61. 

We  can  find  now  the  valuation  of  bonds.  Suppose  the  market 
rate  on  long  terms  on  investments  of  a  certain  class  is  4%.  What  is 
the  value  of  a  bond  for  $20,000  par  value,  payable  in  twenty  years, 
bearing  5%  interest?  This  value  may  be  determined  by  either  of 
two  methods.  We  may  divide  the  bond  into  two  parts,  principal 
and  interest,  and  then  determine  the  present  worth  of  each  for  the 
duration  of  the  bond,  or  we  may  determine  the  present  worth  of 
the  interest  alone,  measuring  it  by  the  excess  of  the  bond  rate  over 
the  market  rate. 

On  the  first  method,  the  principal,  payable  in  twenty  years,  must 
have  to-day  a  present  worth  of  the  par  value  less  twenty  years'  com- 
pound discount.  We  must  now  note  that  the  rate  of  interest  named 
in  the  bond  is  of  no  concern  to  us  except  as  an  index  of  the  amount 
of  annuity  that  the  bond  yields.  On  a  $20,000  bond,  5%  means  an 
annuity  of  $ioco,  and  it  means  nothing  more.  It  does  not  necessa- 


l68  ACCOUNTS 

rily  mean  5%  on  the  investment,  for  the  bond  may  have  cost  more 
or  less  than  $20,000.  In  determining  what  the  bond  is  worth,  we 
must  figure  discount  at  the  market  rate;  for  our  only  criterion  for 
knowing  what  the  bond  is  worth  is  a  comparison  of  it  with  other 
investments.  If  the  market  rate  is  4%,  as  assumed  here,  we  must 
figure  discount,  to  determine  present  worth,  at  that  rate.  The  pre- 
sent worth  at  4%  of  $20,000  due  in  twenty  years  is  $91 27.74,  as  figured 
by  the  process  indicated  on  page  164.  This  is  the  first  item  of  our 
valuation.  We  now  have  twenty  annuities  of  $1000  each,  payable 
at  yearly  intervals,  to  add  to  the  principal.  These  also,  of  course, 
must  be  figured  at  the  market  rate  of  4%.  The  method  is  that  shown 
on  page  166,  finding  the  sum  of  the  present  worth  for  each  of  the 
twenty  annuities.  The  total  is  $13,590.33.  The  bond  is  worth,  then, 
as  follows : 

Present  worth  of  principal,  payable  in  twenty  years,  $9,127.74 

Present  worth  of  annuities,  for  twenty  years,  i3»590-33 

Value  of  bond  $22,718.07 

The  premium  is  this  amount  less  the  principal  of  $20,000,  or  $2718.07. 
To  understand  the  second  method  of  determining  the  value  of 
this  bond  we  must  recognize  that  if  the  rate  of  interest  were  the  same 
as  the  market  rate,  the  duration  of  the  bond  would  be  a  matter  of 
no  consequence.  A  loan  at  the  market  rate  bears  neither  premium 
nor  discount.  We  do  not  need,  therefore,  by  this  method,  to  take 
into  account  the  present  worth  of  the  principal.  We  have  merely 
to  compare  the  rate  of  interest  borne  by  the  bond  with  the  market 
rate,  and  consider  any  excess  or  deficiency  to  be  the  sole  factor  in 
determining  the  premium  or  discount  on  the  bond.  In  this  case  the 
bond  pays  $1000  interest  per  year,  but  at  the  market  rate  the  inter- 
est upon  the  principal  of  the  bond  would  be  but  $800  per  year.  This 
bond,  then,  assures  to  the  holder  an  annuity  above  normal  interest 
of  $200  per  year  for  its  twenty  years'  duration.  The  present  worth 
of  an  annuity  of  $200  for  twenty  years,  therefore,  is  the  premium  on 
the  bond.  This  figure  added  to  the  principal  should  correspond 
exactly  with  the  figure  of  valuation  of  the  bond  by  the  other  method, 
and  except  where  odd  cents  have  been  lost  in  the  figuring,  as  is  Ukely 
to  happen  unless  the  calculation  is  made  very  fine,  the  results  will 
be  identical.   The  present  worth  of  an  annuity  of  $200  for  twenty 


PRINCIPAL  AND   INTEREST  IN  VALUATIONS  1 69 

years  at  4%  is  $2718.07.  This  is  the  premium.  The  total  value, 
therefore,  is  $22,718.07,  as  found  by  the  other  method. 

Let  us  now  add  another  element.  Suppose  the  bond  draws  inter- 
est semiannually.  Then  there  will  be  forty  payments  of  2h%  instead 
of  twenty  payments  of  5%.  The  bond  is  now  clearly  worth  more 
than  before,  for  the  holder  instead  of  waiting  a  year  for  his  first 
interest  receives  one  half  of  it  at  the  end  of  six  months,  and  that  six 
months'  interest  may  be  reinvested.  The  increase  in  value  due  to 
this  shorter  interest  payment  is  equivalent,  therefore,  to  interest  for 
six  months  on  every  second  interest  payment.  That  is  to  say,  one 
half  of  the  first  year's  interest  being  received  at  the  end  of  six  months 
earns  interest  until  the  end  of  the  year.  Then  the  other  half-year's 
interest  earns  interest  exactly  as  under  the  annual  payment  plan. 
Then  a  third  interest  payment  is  made,  and  this  can  be  put  at  inter- 
est until  the  time  for  the  fourth  payment,  which  is  as  it  would  be 
under  the  annual  plan.  So  it  is  every  second  interest  payment  which 
may  be  reinvested  and  earn  more  than  under  the  annual  plan.  The 
difference  is  actually,  at  6%,  such  that  a  bond  yielding  $60.00  on  the 
annual  plan  will  produce  $60.90  when  interest  is  payable  semian- 
nually, $61.36  when  interest  is  payable  quarterly,  and  would  pro- 
duce $61.68  if  it  were  payable  monthly. 

So  far  we  have  taken  simple  cases  of  value  for  a  definite  moment 
of  time,  and  so  far  the  principles  are  complete.  When  we  come  to 
register  values  upon  books,  however,  we  meet  a  new  problem.  Sup- 
pose we  have  bought  a  five-year  5%  bond  with  interest  payable 
semiannually,  of  the  par  value  of  $200,000,  when  the  market  rate  on 
long  time  for  money  loaned  on  security  of  this  class  is  4%.  As  has 
already  been  seen,  the  value  of  this  bond  can  be  determined  by  tak- 
ing either :  (i)  the  present  worth  of  the  principal  of  the  bond  payable 
in  five  years,  plus  the  present  worth  of  the  annuity  (the  amount  of 
interest)  for  five  years;  or  (2)  the  present  worth  of  an  annuity  of 
$1000  for  ten  periods,  payable  at  six-month  intervals,  —  for  since 
the  market  rate  is  4%  and  this  bond  bears  5%,  it  yields  every  half- 
year  $ioco  more  than  the  market  rate  upon  the  par  value  of  the 
bond,  that  is,  $5000  instead  of  $4000.  In  either  case  the  premium 
is  $8982.59.  We  must  remember  why  this  bond  bears  a  premium: 
ihe  bond  constitutes  a  claim  for  interest  at  higher  than  the  market 
rate  for  a  definite  number  of  periods.  When  the  number  of  periods 


I70  ACCOUNTS 

shrinks,  the  value  of  the  bond  shrinks.  When  the  first  of  the  ten 
interest  payments  has  been  made,  but  nine  remain;  and  the  bond 
is  no  longer  a  claim  for  ten  annuities.  Of  course,  only  the  par  value, 
and  not  the  premium,  is  to  be  paid  at  maturity.  In  a  sense,  therefore, 
each  interest  payment  includes,  besides  the  market  rate  of  interest, 
a  return  of  a  part  of  the  premium ;  and,  therefore,  the  premium  re- 
maining, after  each  interest  payment,  must  be  reduced  upon  the 
books,  or  the  figures  v^rill  not  properly  show  the  value  of  the  bond. 
The  problem  is  to  determine  at  what  rate  or  on  what  basis  this  de- 
preciation on  the  value  of  the  bond  shall  be  written  off  the  books. 
This  writing  off  of  depreciation  is  called  "amortisation,"  and  for 
every  investment  at  any  figure  above  par  an  amortisation  table 
should  be  constructed  showing  what  amount  of  the  cost  value  should 
be  at  each  period  written  off.  Amounts  to  be  wTitten  up  if  the  bond 
was  bought  at  a  discount  are  called  "accumulations." 

Several  methods  of  constructing  such  an  amortisation  table  may 
be  followed.  We  will  take  the  most  simple  first.  It  was  assumed 
in  the  case  before  us  that  the  market  rate  of  interest  was  4%. 
The  investor  expects,  therefore,  that  his  bond,  if  it  is  worth  the 
premium  which  he  paid  —  namely,  $8982.59,  —  shall  produce  for 
him  4%  upon  the  total  investment  of  $208,982.59.  Unless  he  gets 
more  than  4%  upon  that  investment  he  receives  nothing  which  can 
be  called  amortisation,  for  he  has  received  back  no  part  of  his  pre- 
mium; but  whatever  he  has  received  in  excess  of  that  sum  must 
be  amortisation.  His  bond  pays  him  in  the  first  half-year  $5000; 
but  2%  semiannual  interest  on  his  original  investment  would  amount 
to  only  $4179.65.  The  difference  between  the  two,  which  is  $820.35, 
must  be  return  of  principal  invested ;  and,  therefore,  is  the  figure  of 
amortisation  for  the  first  year.  We  must  now  show  on  the  books 
that  our  bond  has  shrunk  in  value  $820.35,  that  is,  to  $208,162.24, 
or,  to  express  it  differently,  we  must  show  on  the  books  that  $820.35 
of  principal  has  been  paid  off,  and,  consequently,  only  $208,162.24 
of  the  original  investment  still  remains  in  the  bond.  This  last  figure 
is  called  the  "book  value." 

Six  months  later  the  investor  is  entitled  on  the  4%  basis  to  2% 
on  that  portion  of  the  investment  still  remaining  in  the  bond,  which 
we  have  already  seen  to  be  $208,162.24.  Since,  this  half-year,  he 
receives  in  bond  interest  $5000,  and  interest  on  his  investment  is 


PRINCIPAL  AND   INTEREST  IN  VALUATIONS 


171 


but  $4163.24,  the  difference,  as  in  the  former  case,  is  a  payment  on 
account  of  premium  and  should  be  amortised,  or  subtracted  from 
the  former  valuation  of  the  bond.  This  may  perhaps  best  be  made 
clear  by  a  table  for  the  whole  period  of  five  years  or  ten  interest 
payments.  After  the  explanation  above,  the  table  should  be  readily 
intelligible. 


5^0 

4^ 

Amortisa- 

Date 

Bond 

Interest  on  Last 

X  XlllV/l  LIOU. 

Book  Value 

Interest 

Book  Value 

tion 

1908     Jan.  I 

$208,982.59 

July  I 

$5000.00 

$4179.65 

$820.35 

208,162.24 

1909     Jan.  I 

5000.00 

4163.24 

836.76 

207,325.48 

July  I 

5000.00 

4146.51 

853-49 

206,471.99 

1910     Jan.  I 

5000.00 

4129.44 

870.56 

205,601.43 

July  I 

5000.00 

4112.03 

887.97 

204,713.46 

1911     Jan.  I 

5000.00 

4094.27 

90573 

203,807.73 

July  I 

5000.00 

4076.15 

923-85 

202,883.88 

1912     Jan.  I 

5000.00 

4057.68 

942.32 

201,941.56 

July  I 

5000.00 

4038.83 

961.17 

200,980.39 

1913     Jan.  I 

5000.00 

4019.61 

980.39 

200,000.00 

50000.00 

41017.41 
Proof 

8982.59 

Cost  of  bond 

$208,982.59        Bond  interest 

$50,000.00 

Par 

200,000.00        Interest 

on  investment 
ition 

41,017.41 

Premium 

8,9^ 

I2  59        Amortisc 

8,982.59 

This  table  probably  needs  no  explanation ;  but  its  meaning  may 
well  be  reviewed  by  a  statement  of  just  how  it  was  constructed. 
We  had  at  the  start  just  three  facts  —  the  cost  of  the  bond,  the  rate 
of  interest  on  the  bond,  and  the  market  rate  of  interest.  All  the 
other  figures  are  derived  from  these.  Since  the  bond  interest  is  con- 
stant, the  first  column  may  be  filled  at  once.  Next,  2%,  or  the  inter- 
est for  a  half-year,  is  figured  on  the  cost  of  the  bond,  that  is,  the 
original  book  value.  The  difference  between  bond  interest  and  mar- 
ket interest  (4%  basis)  is  the  amortisation.  The  last  book  value 
less  the  amortisation  is  the  new  book  value.  For  the  next  period  the 
market  rate  is  applied  to  this  book  value,  and  the  difference  between 
that  interest  and  the  bond  interest  is  the  amortisation  for  that  year ; 
and  go  on  to  the  end. 

The  reverse  of  this  process  would  be  adopted  for  bonds  bought 


172  ACCOUNTS 

at  a  discount.  Here,  instead  of  amortisation,  there  would  be  accu- 
mulation, that  is,  a  steady  increase  in  value  due  to  the  nearer  ap- 
proach of  the  day  of  payment;  for,  since  the  bonds  were  bought  at  a 
discount  and  the  par  value  is  to  be  paid  at  the  expiration  of  the  term 
of  the  bond,  every  period  sees  an  increase  in  value  as  the  day  of  final 
payment  approaches.  A  table  follows  for  a  condition  the  exact 
reverse  of  the  amortisation  given. 


Date 

4%  Bond        5%  Interest  on 

Accu- 

Book Value 

Interest        Last  Book  Value 

mulation 

1908  Jan.  I 

$191,247.94 

July  I 

$4,000              $4,781.19 

$781.19 

192,029.13 

1909  Jan.  I 

4,000                4,800.73 

800.73 

192,829.86 

July  I 

4,000                4,820.7s 

820.75 

193,650.61 

1910  Jan.  I 

4,000                4,841.26 

841.26 

194,491.87 

July  I 

4,000                4,862.30 

862.30 

195,354-17 

1911  Jan.  I 

4,000                4,883.86 

883.86 

196,238.03 

July  I 

4,000                4,905-95 

905-95 

197,143.98 

1912  Jan.  I 

4,000                4,928.60 

928.60 

198,072.58 

July  I 

4,000                4,951-81 

951-81 

199,024.39 

1913  Jan.  I 

4,000                4,975-61 
$40,000            $48,752.06 

975-61 

200,000.00 

$8,752.06 

Par 

$200,000.00        Interest  on 

investment 

$48,752.06 

Cost 

191,247.94        Bond  interest 

40,000.00 

Accumulation 

$  8,752.06        Accumulation 

$  8,752.06 

In  this  case  the  book  value  of  the  bond  is  changing  not  because  a 
part  of  the  investment  has  been  paid  back,  as  is  the  case  with  a 
bond  at  a  premium,  but  because  the  investment  made,  and  yield- 
ing less  than  the  market  or  basis  rate,  is  accumulating  compound 
interest  on  the  deficiency  in  periodic  bond  interest.  It  will  be  noted 
that  the  discount  here  is  less  than  the  premium  in  the  other  case, 
though  the  "difference  of  interest"  is  the  same,  or  $1000.  The  rea- 
son is  that  the  reversal  of  rates  makes  the  basis  or  discounting  rate 
five  instead  of  four,  and  hence  the  present  worth  of  an  annuity  of 
the  difference  of  interest  (the  higher  discount  giving  the  lower  pres- 
ent worth)  is  less. 

Under  a  table  either  of  amortisation  or  of  accumulation,  it  is 
obvious  that  if  one  buys  the  bond  at  a  correct  price  at  any  stage 
during  the  process  the  value  which  he  should  pay  is  the  book  value 
as  recorded  in  the  table,  and  the  table  will  remain  correct  for  the 
rest  of  the  life  of  the  bond;  for  in  each  case  the  interest  on  the  4% 
basis  has  been  figured  on  the  book  value  for  the  preceding  period, 


I 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 73 

and  that  furnishes  the  amortisation  and  in  turn  the  new  book  value, 
so  that  at  the  end  of  the  time  the  book  value,  whatever  it  is,  will 
have  been  amortised. 

If,  during  the  life  of  the  bond,  the  market  rate  of  interest  should 
change,  the  amortisation  schedule  cannot  be  changed  to  correspond, 
for  since  the  purchase  was  on  a  different  basis,  a  new  rate  will  not 
amortise  at  maturity.  The  only  effective  method  of  registering  a 
change  in  the  market  rate  (but,  of  course,  it  is  only  the  market  rate 
on  long  terms  that  concerns  amortisation  tables,  and  that  does  not 
change  often)  is  to  charge  or  credit  to  profit  and  loss  any  difference 
between  the  old  book  value  and  the  value  of  the  bond  determined 
anew  by  the  methods  already  described  on  page  168.  Then  a  new 
amortisation  schedule,  based  on  the  new  rate,  may  be  made  for 
the  unexpired  time  of  the  bond  so  that  par  shall  be  attained  at  the 
end  of  the  time.  To  illustrate,  if,  at  the  end  of  the  five  periods, 
when  the  book  value  is  $204,713.46,  the  rate  of  interest  in  the  market 
falls  to  si%y  this  bond  will  be  worth  more  than  before,  for  its  inter- 
est is  now  really  an  annuity  for  $1500  per  half-year  instead  of  $1000 
($5000  bond  interest  less  $3500  market  interest).  Its  value  will  be 
$207,121.78.  If  this  sum  were  to  be  adopted,  writing  up  the  book 
value,  a  new  schedule,  displacing  that  previously  worked  out, 
should  be  used  for  future  amortisations.  Such  a  schedule  would 
work  down  to  par,  of  course,  for  it  would  be  based  on  correct  figur- 
ing, as  shown  below: 


Date 

5% 

3.5% 

Amortisation 

Book  Value 

10  July  I 

$207,121.78 

II  Jan.  I 

$5000 

$3624.63 

$1375-37 

205,746.41 

July  I 

5000 

3600.57 

1399-43 

204,346.98 

12  Jan.  I 

5000 

3576.07 

1423-93 

202,923.05 

July  I 

5000 

3551-15 

1448.85 

201,474-20 

13  Jan.  I 

5000 

3525-80 

1474-20 

200,000.00 

As  a  matter  of  fact,  however,  few  accountants  would  recommend 
changing  the  value  on  the  books.  As  we  shall  see  later,  the  best 
accounting  uses  cost  as  a  basis.  An  increase  of  value  in  a  thing  still 
held  is  not  profit:  profit  cannot  arise  until  the  thing  is  sold.  Until, 
then,  the  bond  is  sold,  its  new  value  had  best  not  appear  on  books 
of  account  —  and  when  sold  it  disappears  as  property  and  needs 
no  schedule  of  amortisation.  So  a  change  in  market  interest  down- 
ward need  not  affect  either  amortisation  or  accumulation  tables; 


174  ACCOUNTS 

for  a  reduction  in  basis  rates  increases  "difference  of  interest^' 
with  bonds  at  a  premium,  and  this  increases  values,  but  it  reduces 
"difference  of  interest''  with  bonds  at  a  discount,  and  this  by  re- 
ducing the  discount  increases  values. 

A  change  of  market  interest  upward,  however,  reduces  the  value 
of  bonds  —  by  reducing  the  excess  of  bond  interest  for  bonds  at  a 
premium  and  by  increasing  the  deficiency  of  bond  interest  (and 
therefore  the  discount)  for  bonds  at  a  discount.  A  new  problem  — 
not  necessarily  the  reverse  of  the  other,  and  one  of  importance  in 
other  connections  as  well  as  in  bond  interest  —  is  raised  in  deter- 
mining whether  the  book  value  of  the  bonds  should  be  reduced  and 
new  tables  should  be  made. 

When  the  basis  rate  goes  up  (say  from  4%  to  4^%)  and  the  bonds 
go  down  in  value,  has  the  owner  lost  capital  (in  the  shrinkage  of 
the  bonds),  or  has  he  lost  revenue  (in  the  reduced  net  revenue 
from  the  bonds  in  comparison  with  the  market  rate)?  He  has 
surely  lost  one  or  the  other.  If  he  considers  his  capital  unim- 
paired, he  must  apply  so  much  of  his  bond  interest  to  amortisa- 
tion that  his  net  revenue  is  only  4%  though  investments  of  this 
type  should  yield  4^%,  and  therefore  he  is  losing  revenue.  If  he 
desires  to  take  from  his  bond  interest  the  4!%  normal  present  in- 
terest on  his  investment,  not  enough  amortisation  will  be  left  to 
bring  his  bond  down  to  par,  and  his  capital  will  have  shrunk  heav- 
ily. Which  he  shall  do  will  depend  upon  his  basis  of  capitaliza- 
tion. If  he  wishes  to  have  his  balance  sheet  represent  the  cost  of 
assets  to  the  business  —  treating  the  business  as  a  going  concern 
rather  than  as  a  group  of  assets  for  sale  —  he  will  keep  his  former 
bond  valuation  and  allow  the  income  sheet  to  show  net  interest 
returns  at  less  than  the  new  market  rate.  If  he  wishes  his  bal- 
ance sheet  to  show  cost  of  dupHcation,  or  sale  value,  he  will  write 
down  his  bonds  to  the  new  value  based  on  the  new  basis  rate.  This 
will  yield  on  his  income  sheet  the  new  normal  rate  on  his  invest- 
ment. The  choice  between  the  two  principles  of  balance-sheet  val- 
uation is  discussed  in  the  next  chapter. 

If  he  decides  to  change  his  valuation,  the  problem  of  bookkeep- 
ing entry  still  remains.  There  is  a  common  opinion  that  profits  are 
impossible  until  losses  have  been  made  good.  On  this  principle,  all 
bond  interest  received  on  these  bonds  would  be  treated  as  amortisa- 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 75 

tion  and  credited  to  bonds  until  the  bonds  should  be  brought  down 
to  their  value  at  the  new  basis  rate.  This  takes  the  loss  out  of  rev- 
enue, and  with  the  maximum  rapidity.  The  theory,  however,  is 
mistaken.  It  is  true  that  no  operating  profits  are  possible  until  all 
operating  losses  have  been  met,  but  it  is  not  true  that  there  is  no 
income  from  investments  in  any  year  if  the  losses  on  principal  in 
some  investments  are  greater  than  the  income,  for  that  year,  of  all 
investments.  The  investments  that  were  not  destroyed  earned  in- 
come for  the  period,  and  what  they  earned  does  not  cease  to  be 
income  merely  because  some  capital  loss  elsewhere  happens  to  fall 
within  that  earning  period.  The  truth  is  not  shown  by  the  books 
unless  both  facts  are  indicated.  In  the  case  of  the  bonds,  then,  the 
loss  of  capital,  if  we  wish  to  consider  it  a  capital  loss  rather  than 
one  of  revenue,  should  be  entered  as  a  debit  to  Capital  Surplus  (or 
Capital  Losses)  and  a  credit  to  Bonds.  It  may  be  made  up  out  of 
revenue,  of  course,  if  so  desired;  but  in  that  case  it  should  be  re- 
ported not  as  a  deduction  from  income,  or  cost,  but  as  a  disposition 
of  surplus  income.  Assuming  that  the  new  rate  is  4^%,  the  bond 
value  will  be  $202,339.73,  ^^^  ^^^  ^^w  table  will  read  as  follows: 


Date 

5% 

4.5% 

Amortisation 

Book  Value 

1910  July  I 

$202,339.73 

191 I  Jan.  I 

$5000 

$4552.64 

$447-36 

201,892.37 

July  I 

5000 

4542.58 

45742 

201,434.95 

191 2  Jan.  I 

5000 

4532.28 

467.72 

200,967.23 

July  I 

5000 

4521.76 

478.24 

200,488.99 

1913  Jan.  I 

5000 

4511.01 

488.99 

200,000.00 

Itmay  be  worth  while,  beforepassing  on,  to  note  that  the  precision 
with  which  the  amortisation  schedule  exactly  writes  off  the  original 
premium  may  look  suspicious.  If  our  suppositions  are  correct,  how- 
ever, it  is  boimd  to  work  with  complete  accuracy.  We  exactly  de- 
termined the  rightful  premium  of  the  bond  by  careful  calculation 
of  the  amount  of  accumulation  of  excess  interest  over  the  market 
rate,  showing  $8982.59.  If  now  we  reverse  the  process  and  see  how 
much  each  half-year  we  are  getting  on  the  4%  basis  and  subtract 
that  from  the  amount  paid  by  the  bond  on  the  5  %  basis,  we  must  as 
inevitably  destroy  the  premium  of  $8982.59  as  in  the  other  case  we 
built  it  up.  Such  a  schedule  worked  out  on  the  plan  given  cannot 
fail  to  produce  a  correct  result,  unless  by  some  dropping  of  fractions, 
in  the  disregard  of  portions  of  a  cent,  the  scheme  is  to  a  minute 


176  ACCOUNTS 

degree  thrown  out  of  balance.  This  is  made  clearer  by  noting  that 
as  the  premium  is  nothing  but  the  present  worth  of  an  annuity  of 
the  "difference  of  interest,"  so  the  various  amortisations  are  noth- 
ing but  the  present  worth  of  the  different  installments  of  annuity. 
A  table  of  2%  ratios,  substituted  for  the  upper  half  of  the  5% 
table  on  page  165,  would  have  given  us,  reading  up  from  $1000,  the 
following:  $980.39,  $961.17,  $942.32,  $923.85,  $905.73,  etc.;  and 
hence  these  figures  are  simply  the  present  worths  of  $1000  payable 
in  6  mos.,  12  mos.,  etc.,  at  a  rate  of  4%  per  year,  or  2%  per  half 
year.  A  glance  at  the  amortisation  table  on  page  171  will  show 
that  these  figures  are  exactly  the  amortisations  of  the  bond  under 
discussion.  In  other  words,  just  as  the  premium  is  the  present 
worth  of  an  annuity  of  the  difference  of  interest,  and  as  the  total 
amortisation  just  destroys  or  absorbs  the  premium,  so  each  amor- 
tisation is  the  present  worth  of  the  difference  of  interest  for  one 
period. 

It  may  seem  as  if,  since  the  premium  equals  only  the  present 
worths  of  the  difference  of  interest,  the  investor  gets  back  his  pre- 
mium but  without  interest  on  it;  for  the  total  of  the  column  for 
amortisation  (page  171)  shows  exactly  the  premium  required.  If 
that  were  the  case,  the  purchaser  of  the  bond  would  not  be  getting 
the  basis  rate  on  his  investment  but  on  only  part  of  it.  Since,  how- 
ever, we  have  applied  the  basis  rate  to  the  last  book  value,  which 
includes  all  unredeemed  premium,  we  see  that  the  whole  invest- 
ment gets  the  basis,  or  market,  rate.  We  saw  a  moment  ago  that 
each  amortisation  is  the  same  as  the  present  worth  of  one  install- 
ment of  annuity  of  the  difference  of  interest.  The  order  is  reversed, 
however:  the  last  amortisation  is  the  first  or  nearest  present  worth. 
The  reason  is  the  fact,  about  interest  on  premium,  which  we  have 
just  seen.  The  bond  interest  must  pay  not  only  the  premium  but 
interest  on  the  unredeemed  or  unamortised  premium ;  at  the  time 
of  the  first  amortisation  many  other  installments  of  ''difference  of 
interest"  are  still  unpaid  and  the  interest  on  them  must  be  met 
out  of  the  bond  interest  before  anything  is  left  for  amortisation; 
the  excess  of  bond  interest  is  not  yet  enough  to  pay  both  such  in- 
terest on  unredeemed  premium  and  the  present  worth  of  the  first 
installment  of  annuity;  and  the  interest  on  unpaid  installments  of 
annuity  is  exactly  equal  (for  reasons  to  be  shown  later)  to  the  dif' 


J 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 77 

ference  between  the  first  amortisation  and  the  first  present  worth. 
So  the  first  amortisation  is  less  than  the  first  present  worth  by  just 
enough  to  reduce  it  to  the  last  present  worth.  The  two  sets  of  fig- 
ures run  in  opposite  directions  and  pass  in  the  middle.  Then  the 
excess  of  bond  interest  is  more  than  enough  to  pay  interest  on  the 
unredeemed  premium,  and  the  amount  left  for  amortisation  goes 
up  the  scale  to  meet  the  earlier  present  worths.  So  the  first  present 
worth  is  the  last  amortisation,  and  vice  versa. 

Still  another  table  may  make  all  this  clearer.  Let  us  see  for  each 
period  the  ''difference  of  interest"  and  its  application.  The  follow- 
ing table  corresponds  with  that  given  on  page  171,  but  omits  the 
par  of  the  bonds,  and,  because  of  space  requirements,  the  dates. 


Bond 

Basis  Inter- 

Difference 

Basis  Inter- 

Balance 

Premium 

Interest 

est  on  Par 

o£  Interest 

est  on  Premium 
Unredeemed 

for  Amor- 
tisation 

Unredeemed 
$8982.59 

$5000 

$4000 

$1000 

$179.65 

$820.35 

8162.24 

5000 

4000 

1000 

163.24 

836.76 

732548 

5000 

4000 

1000 

146.51 

85349 

6471.99 

5000 

4000 

ICXXD 

129.44 

870.56 

5601.43 

5000 

4000 

1000 

112.03 

887.97 

4713.46 

5000 

4000 

1000 

94.27 

905-73 

3807.73 

5000 

4000 

1000 

76.15 

923-85 

2883.88 

5000 

4000 

1000 

57.68 

942.32 

1941.56 

5000 

4000 

1000 

38.83 

961.17 

980.39 

5000 

4000 

1000 

19.61 

980.39 

0000.00 

A  short  cut  for  working  out  an  amortisation  schedule  may  be 
worth  mention  here.  A  reference  to  the  schedule  already  given  will 
show  that  the  column  of  amortisation  gives  sums  each  of  which  is 
102%  of  the  sum  before  it.  In  other  words,  if  each  amortisation 
were  put  at  interest  on  the  4%  basis  for  the  succeeding  half-year,  it 
would  produce  at  the  end  of  that  succeeding  period  exactly  the  sum 
which  is  at  the  end  of  that  period  amortised  from  the  interest  pay- 
ment. The  reason  for  this  is  evident.  Each  amortisation  decreases 
the  book  value,  and  hence  decreases  the  2%  interest  on  the  book 
value.  Since  the  bond  interest  is  constant,  and  the  market  interest 
is  reduced  each  time  by  2%  on  the  last  amortisation,  each  amortisa- 
tion is  2%  larger  than  the  one  before  it.  When,  then,  our  first  amor- 
tisation has  been  determined,  the  column  may  be  filled  out  at  once 
by  adding  2  %  each  time. 

Indeed,  it  would  be  possible  to  work  out  an  amortisation  table 


178  ACCOUNTS 

without  a  knowledge  of  even  the  book  value,  if  only  the  premium 
were  known,  —  however  big  the  par  value  might  be.  All  we  need 
to  know  is  what  annuity  invested  at  the  market  rate  for  the  required 
number  of  periods  would  amount  to  the  premium.  It  is  easy  to  de- 
termine the  sum  that  an  annuity  of  $1.00  will  amount  to.  The  re- 
quired sum  divided  by  the  amount  of  a  $1.00  annuity  will  give  the 
required  amortisation.  To  illustrate  it  here,  an  annuity  of  $1 .00  will 
for  ten  periods  at  2%  attain  to  $10,941%.  Our  premium,  $8982.59, 
divided  by  this  sum  gives  us  $820.35,  our  first  amortisation.  This, 
multiplied  by  1.02  (for  the  reason  given  in  the  last  paragraph),  will 
give  the  next  amortisation;  and  so  on. 

For  one  accustomed  to  logarithms,  all  this  figuring  is  compara- 
tively easy,  though  sometimes  tedious.  Elaborate  interest  and 
bond  tables  have  been  published  for  those  who  do  not  care  to  do 
their  own  figuring.  Interest  tables  for  a  wide  range  of  rates  (so 
that  quarterly  or  semi-annual  compounding  can  be  used)  with 
schedules  for  amounts,  present  worths,  amounts  of  annuity,  pres- 
ent worths  of  annuity,  and  sinking  fund  growth  to  attain  certain 
accumulations,  cover  a  large  range  of  periods.  Bond  tables  give 
to  the  nearest  cent,  at  common  rates  of  interest,  the  value  of  bonds, 
at  a  wide  range  of  basis  rates,  maturing  in  every  period  for  long 
terms.  The  difference  in  bond  value  between  two  dates  on  such  a 
table  shows  the  amortisation,  of  course. 

Lastly,  the  table  may  be  constructed  entirely  backwards  from 
the  date  of  maturity.  The  process  is  interesting  because  it  illus- 
trates the  fact  that  no  mystery  hangs  about  bond  values  and  basis 
rates  and  amortisation,  for  this  last  method  applies  only  the  sim- 
plest common  sense;  and  yet  many  investors  understand  so  Httle 
the  mathematical  principles  by  which  their  bonds  are  valued  that 
many  of  them  do  not  know  whether  they  have  lost  or  gained  on 
bond  sales.  If  interest  is  paid  semi-annually,  six  months  before 
maturity  the  value  of  a  good  bond  is  clearly  the  present  worth  of 
its  par  plus  the  present  worth  of  the  final  interest  payment.  In 
our  case,  therefore,  it  is  the  $200,000  of  par,  plus  the  final  $5000 
bond  interest,  divided  by  1.02  (the  true  discount  rate).  This  gives 
$200,980.39  —  or  the  figure  of  our  original  table.  Obviously,  then, 
since  the  value  shrinks  in  the  last  period  $980.39,  that  figure  is  the 
final  amortisation.   We  may  continue  the  process.   What  is  the 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 79 

value  six  months  earlier?  It  is  the  present  worth  of  the  $200,980.39 
just  found,  plus  the  $5000  bond  interest  due  six  months  before 
maturity,  divided  by  1.02.  We  find  this  to  be  $201,941.56;  and  our 
amortisation  (the  difference  between  this  value  and  the  next)  is 
$961.17;  our  results  agree  with  the  table  as  before.  The  process 
could  be  continued  to  the  original  purchase  date. 

Up  to  this  point  the  assumption  has  been  that  the  purchase  was 
made  on  an  interest  date,  and  that  the  book  value  is  preserved  on  the 
books  as  of  such  a  date.  The  actual  conditions  are  often  otherwise ; 
for,  first,  bonds  are  bought  between  interest  dates,  and,  second,  books 
are  intended  to  show  valuations  at  the  end  of  fiscal  years.  In  either 
or  both  of  these  circumstances  a  somewhat  different  schedule  of 
amortisation  must  be  provided.  The  difference  between  such  a 
schedule  of  amortisation  and  the  one  given  above  is  based  on  the 
fact  that  the  natural  time  to  value  a  bond  is  at  an  interest  date; 
for  interest  is  compounded  at  interest  dates  and  at  no  other  time.^ 
Purchasing  or  selling  or  valuing  a  bond  at  any  other  time  theoreti- 
cally involves  allowance  for  compounding  the  interest  at  an  extra 
time, —  say  two  months  after  the  last  interest  date  instead  of  six. 
In  practice,  however,  since  the  computation  is  somewhat  laborious 
and  the  difference  small,  the  interest  and  the  amortisation  are 
usually  taken  as  a  proportion  of  the  total  interest  and  amortisation 
of  the  whole  period,  —  say,  for  two  months,  one  third  the  figure 
for  the  half-year  in  which  it  occurs,  —  using  as  a  basis  the  book 
value  at  the  last  interest  date.  If,  for  illustration,  we  assume  the 
bond  already  discussed  on  page  171  to  be  bought  on  February  i, 
we  find  the  amortisation  for  the  first  half-year  to  be  $820.35,  and 
the  interest  to  be  $4179.65;  and  the  amortisation  and  the  interest 
on  February  i  will  be  $136.72  and  $696.61,  respectively,  or  one 
sixth.  This  amortisation  subtracted  from  the  January  book  value 
gives  the  book  value  for  the  day  of  purchase,  February  i.  We  start 
our  amortisation  table  at  this  point,  therefore,  and  continue  it 
exactly  hke  the  schedule  above  except  that  the  July  items  will  have 
been  reduced  by  the  amount  of  the  February  items,  as  follows: 

*  This  is  not  merely  a  theoretical  compounding,  but  may  be  actual.  Interest 
money  paid  may  be  invested  and  at  once  begin  to  earn  interest.  That  is  true  com- 
pounding, and  the  possibility  of  it  is  the  only  warrant  for  figuring  theoretical  com- 
pound interest. 


I80 

ACCOUNTS 

Date 

5^. 
Bond 

40;^  Interest 
on  Last  Interest- 

Amortisa- 

Book Value 

Interest 

date  Valuation 

tion 

1908 

Feb.  I 

$208,845.87' 

July  I 

$4,166.67' 

$3,483-04' 

$683.63 

208,162.24 

1909 

Jan.  I 

5,000.00 

4,163.24 

836.76 

207,325.48 

When,  as  already  suggested,  an  amortisation  table  must  be  con- 
structed to  show  valuation  at  dates  other  than  interest  dates,  as  at 
the  end  of  fiscal  years  not  corresponding  with  those  of  the  bonds, 
another  device  must  be  employed.  Let  us  suppose  that,  with  the 
firm  holding  the  bond  figured  above,  the  fiscal  year  ends  March  31. 
We  then  desire  a  valuation  for  April  i.  This  would  be  figured  as 
we  figured  the  February  valuation,  or  just  halfway  between  the 
valuation  for  January  and  that  for  July,  or  $208,572.42.  The  time 
elapsed  since  February  i  (the  date  of  purchase)  is  one  third  of  a 
half-year,  and  the  bond  interest,  the  earned  interest,  and  the  amor- 
tisation, consequently,  will  be  one  third  that  for  the  half-year,  or 
$1666.67,  $1393.22,  and  $273.45,  respectively  (based,  as  were  the 
February  figures,  on  the  January  book  value).  Now  that  we  have 
once  timed  our  valuation  to  accord  with  the  fiscal  years,  however, 
we  do  not  need  again  to  figure  valuation  at  interest  dates  until  the 
bond  is  sold  or  reaches  maturity.  We  can,  if  we  wish,  keep  our 
valuation  at  this  fixed  interval  from  the  valuation  at  interest  dates, 
making  a  schedule  for  this  purpose.  Here,  for  instance,  since  our 
April  valuation  is  midway  between  that  for  January  and  that  for 
July,  we  may  keep  the  figures  of  our  new  schedule  constantly  mid- 
way between  those  of  the  other,  showing  valuation  for  April  and  for 
October  only.  To  be  sure,  the  bond  interest  will  not  be  received  on 
the  dates  mentioned,  but  our  entry  of  that  interest  in  the  schedule  is 
not  to  enable  us  to  keep  run  of  interest  collections  but  solely  to  show 

*  This  calculation  is  concerned  with  only  the  capital  portion  of  the  bond,  and 
takes  no  cognizance  of  interest  accrued.  The  market  value  on  February  i  would  be 
this  book  value  plus  one  month's  interest.  The  bond  interest  for  July  i,  similarly,  is 
here  entered  as  for  only  five  sixths  of  a  half-year,  though  $5000  will  be  paid  at  that 
time.  The  purpose  of  this  interest  column  is  solely  to  show  how  much  annuity  has 
been  received  on  capital  investment;  and  in  this  case  $833.33  is  supposed  to  have  been 
paid  in  advance  out  of  the  $5000  to  be  received. 

^  This  figure  is  taken  on  the  basis  of  the  January  book  value,  as  indicated  above, 
for  the  half-year  was  arbitrarily  divided;  and  since  the  first  portion  was  taken  on 
that  basis,  the  second  must  be  similarly  figured. 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS 


i8i 


ate 

5^  Bond 

40/^  Interest  on 

Last  Amortisa- 

Book 

Interest 

Interest-date  Valuation      tion 

Value 

Jan.  I 

$208,982.59 

Feb.  I 

$  ^33-33 

$696.61 

136.72 

208,845.87 

Apr.  I 

1,666.67 

1,393-22 

273-45 

208,572.42 

July  I 

2,500.00 

2,089.82 

410.18 

208,162.24 

Oct.  I 

2,500.00 

2,081.62 

418.38 

207,743.86 

Jan.  I 

2,500.00 

2,081.62 

418.38 

207,325.48 

Apr.  I 

2,500.00 

2,073.25 

42675 

206,898.73 

July  I 

2,500.00 

2,073.26 

426.74 

206,471.99 

Oct.  I 

2,500.00 

2,064.72 

43528 

206,036.71 

Jan.  I 

2,500.00 

2,064  72 

435.28 

205,601.43 

Apr.  I 

2,500.00 

2,056.01 

443-99 

205,157.44 

July  I 

2,500.00 

2,056.02 

443.98 

204,713.46 

Oct.  I 

2,500.00 

2,047.13 

452.87 

204,260.59 

Jan.  I 

2,500.00 

2,047.14 

452.86 

203,807.73 

Apr.  I 

2,500.00 

2,038.08 

46192 

203,345-81 

July  I 

2,500.00 

2,038.07 

461.93 

202,883.88 

Oct.  I 

2,500.00 

2,028.84 

471.16 

202,412.72 

Jan.  I 

2,500.00 

2,028.84 

471.16 

201,941.56 

Apr.  I 

2,500.00 

2,019.42 

480.58 

201,460.98 

July  I 

2,500.00 

2,019.42 

480.58 

200,980.40 

Oct.  I 

2,500.00 

2,009.80 

490.20 

200,490.20 

Jan.  I 

2,500.00 

2,009.80 

490.20 

200,000.00 

ate 

5^  Bond 

4<%  Interest  on     Amortisa- 

Book 

Interest 

Book  Value^ 

tion 

Value 

Feb.  I 

$208,845.87 

Apr.  I 

$1666.67 

$1393.22 

$273.45 

208,572.42 

Oct.  I 

5,000.00 

4,171.44 

828.56 

207,743.86 

Apr.  I 

5,000.00 

4,154.87 

845-13 

206,898.73 

Oct.  I 

5,000.00 

4,137.98 

86202 

206,036.71 

Apr.  I 

5,000.00 

4,120.73 

879-27 

205,157.44 

Oct.  I 

5,000.00 

4,103.15 

896.85 

204,260.59 

Apr.  I 

5,000.00 

4,085.22 

914.78 

203,345.81 

Oct.  I 

5,000.00 

4,066.91 

933-09 

202,412.72 

Apr.  I 

5,000.00 

4,048.26 

951-74 

201,460.98 

Oct.  I 

5,000.00 

4,029.22 

970.78 

200,490.20 

Jan.  I 

2,500.00 

2,009.80 

490.20 

200,000.0a 

1908 


1909 


I9I0 


I9II 


I9I2 


I9I3 


1908 


1909 


I9I0 


I9II 


I9I2 


I9I3 

^  It  will  be  noted  that  interest  and  amortisation  for  Apr.  i,  1908,  and  Jan.  i, 
1913,  are  figured  on  the  book  values  for  the  last  interest  dates,  Jan.  i,  1908,  and 
July  I,  19 1 2,  respectively;  for  only  a  part  of  the  bond  interest  for  the  current  half- 
year  has  at  these  points  been  apportioned  between  interest  and  amortisation,  and 
the  rest  must  now  be  apportioned.  The  interest  on  all  other  dates  is  based  on  the 
last  book  value, —  which  is  midway  between  book  values  on  interest  dates, —  and 
is  the  same  as  the  sum  of  the  figures  for  the  two  corresponding  quarters  of  the 
preceding  table. 


1 82  ACCOUNTS 

what  amortisation  to  record ;  and,  for  this  purpose,  the  actual  date 
of  receipt  is  of  no  consequence.  Our  schedule  will  therefore  run  as 
regularly  as  our  first  except  for  the  short  initial  periods  and  the  short 
final  period,  —  though  of  course  the  figures  will  be  different  (since 
the  dates  of  the  book  values  will  be  different).  The  only  complica- 
tion is  the  possibility  of  error  in  faihng  to  note  that  the  interest  for 
the  last  short  period  is  based  not  on  the  last,  or  October  book  value, 
but  on  that  for  July,  just  as  the  first  April  valuation  was  based  on 
that  for  January.  The  reason  is  this :  we  have  started  our  table  with 
a  halfway  figure,  midway  between  valuations  at  interest  dates ;  our 
subsequent  amounts  for  interest  and  for  amortisation,  since  they 
were  based  on  the  last  book  value,  lay  half  in  each  half-year,  —  in- 
cluded half  the  interest  and  half  the  amortisation  of  the  first  half- 
year  and  half  those  of  the  second  half-year ;  consequently,  when  we 
figure  finally  for  January,  19 13,  we  must  figure  interest  and  amortisa- 
tion not  on  the  last  October  value  (which  took  account  of  only  half 
the  July- January  interest  and  amortisation)  but  on  the  July  book 
value  itself,  so  as  to  include  all  that  belongs  to  the  year.  The  sched- 
ule shown  gives  complete  figures  for  quarters,  with  the  April  and 
October  figures  based  on  the  values  for  January  and  July;  below 
it  is  another  schedule  showing  the  April  and  October  figures  only. 
A  comparison  of  the  two  tables  shows  the  relation  between  them; 
especially  if  one  notes  that  the  interest  and  the  amortisation  of  the 
second  schedule  are  equal  to  the  sum  of  unhke  quarter-years  of 
the  first,  so  that  the  figures  for  January,  19x3,  must  be  based  on  the 
July  book  value. 

In  practice  the  last  amortisation  will  be  Whatever  is  enough  to 
bring  the  bond  to  par,  and  one  need  not  figure  it  from  the  difference 
between  bond  interest  and  basis  interest;  but  most  accountants  like 
to  prove  their  work  by  figuring  it.  The  interesting  feature  of  this  fig- 
uring of  basis  interest  on  the  book  value  for  the  last  interest-date 
is  that  no  such  book  value  is  preserved  under  the  second  of  the  two 
tables  shown,  and  hence  none  is  available.  It  can  be  got,  however, 
by  analysis.  Of  course  the  basis  interest  on  the  par  is  known,  for 
it  never  changes,  and  therefore  it  may  be  figured  directly  for  the 
short  period;  the  premium,  however,  is  constantly  changing,  and 
the  task  is  to  find  it  for  the  skipped  interest  date;  since,  however, 
the  premium  left  unredeemed  is  for  a  known  part  of  the  final  inter' 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  1 83 

est  period,  the  premium  to  be  reduced  in  the  full  period  can  be 
learned  from  it.  In  the  case  in  hand,  for  example,  the  $490.20  pre- 
mium on  October  i  must  be  half  that  of  July  i ,  for  the  periods  were 
split  evenly.  The  basis  interest  will  then  be  for  three  months  on 
$980.40,  or  $9.80.  This  added  to  our  basis  interest  on  the  par,  or 
$2000,  gives  $2009.80  for  the  short  period,  as  given  in  the  table. 
This  gives  an  interesting  rule  of  thumb :  to  the  interest  at  the  basis 
rate  for  the  short  period  on  the  par  add  the  interest  at  the  basis 
rate  for  a  full  period  on  the  premiimi.  The  last  premium  shown 
is  a  part  only  of  that  belonging  to  the  last  full  period.  The  interest 
rate  to  be  appHed  to  the  full  premium,  moreover,  is  for  the  same 
fractional  part  of  a  period.  To  apply  the  full  rate  to  a  part  principal 
is  the  same  as  applying  a  part  rate  (the  same  fractional  part)  to 
the  whole  principal.  Hence  the  rule. 

Always,  it  is  to  be  noted,  the  market  rate,  or  basis,  considers  the 
element  of  risk.  On  many  bonds  a  basis  of  7%  is  not  too  high.  The 
basis  is  the  market  rate  for  bonds  of  that  degree  of  security,  and  as 
the  judgment  of  security  varies,  so  varies  the  basis  rate.  Of  two 
bonds  of  identical  terms  (say,  twenty-year  term,  with  interest  at  5  %) 
one  may  require  that  6%  be  used  as  a  basis,  because  the  issuing 
company  is  in  a  business  more  or  less  precarious  as  to  both  earnings 
and  solvency,  and  the  other  may  be  safely  taken  at  4%,  because 
the  interest  payments  are  so  sure  that  virtually  all  element  of  risk 
has  been  eHminated.  Both  earning  capacity  and  probable  ultimate 
solvency  are  of  concern  to  bond  holders,  though  in  varying  de- 
grees according  as  the  bonds  carry  mortgage  provision  or  not. 
Two  bonds  with  the  same  probability  of  payments  for  interest 
when  due  may  require  different  basis  rates  for  purposes  of  valua- 
tion. In  one  case  the  bondholders  may  have  a  mortgage  Hen  on  a 
property  which  they  know  should  yield  good  profits,  and  so  they 
know  that,  even  though  it  should  fall  into  bad  hands,  on  default  of 
interest  they  could  foreclose  on  the  property  and  take  it  under 
their  own  management  —  with  every  reasonable  assurance  of 
success.  In  the  other  case,  they  may  have  no  lien  and  no  assurance 
that  the  property  will  be  put  on  a  sound  footing  if  it  ever  falls  by 
the  wayside.  A  man  will  lend  to  the  first  at  a  lower  basis  rate  (that 
is,  will  buy  bonds  at  a  higher  price)  than  to  the  second.  Again,  a 
lender  may,  for  a  good  rate  of  interest  promised,  take  a  bond  on  a 


184  ACCOUNTS 

venture,  knowing  that  he  may  fail  to  collect  all  his  interest,  but 
thinking  that  on  a  sufficient  number  of  ventures  he  will  reap  in 
the  end  an  average  return  —  if  only  he  is  sure  that  his  principal 
is  safe;  but  he  may  refuse  another  on  the  same  assurance  regard- 
ing the  interest  rate  because  he  has  less  assurance  regarding  the 
security  of  his  principal.  If  he  takes  both,  he  will  demand  a  price 
that  shall  equalize  the  risks  —  which  is  the  same  as  putting  the  two 
bonds  on  different  basis  rates. 

Up  to  this  point,  it  has  been  assumed  that  the  price  of  the  bond 
was  determined  on  a  known  market  basis.  Altogether  common  is 
the  reverse  condition,  under  which  we  must  determine  the  market 
basis  from  the  known  price ;  for  often  bonds  are  sold  at  an  arbitrary 
figure,  determined  by  market  conditions,  and  this  is  taken  as  an  in- 
dication of  the  esteem  in  which  the  market  holds  such  bonds,  that 
is,  determines  the  market  basis.  Whether  it  is  possible  to  ascertain 
the  exact  return,  in  percentage,  that  a  purchaser  will  get  from  a  bond 
at  a  known  price  depends  upon  the  meaning  attached  to  the  word 
''return."  Sometimes  this  is  made  to  include  a  supposition  of  rein- 
vestment of  the  amortised  premium.  In  such  a  case,  assuming  a 
fixed  rate  on  reinvestments,  the  rate  of  return  can  be  mathematically 
determined.  Otherwise  it  cannot,  for  mathematicians  have  not 
learned  how  to  solve  equations  containing  unknown  quantities  of 
high  degree.  The  usual  means  of  approximating  the  unknown  rate 
is  reference  to  published  bond  tables.  These  show  the  value  of  bonds 
of  different  terms  and  at  different  rates,  figured  down  to  great  detail 
—  by  the  methods  described  above.  When  one  has  found  the  valua- 
tion nearest  to  the  price  actually  paid  for  a  bond,  a  reference  to 
the  table  shows  the  approximate  rate.  Such  residue  or  discrepancy 
as  may  occur  can  then  be  amortised  by  adding  or  subtracting  a 
proper  sum  at  each  step  in  the  amortisation  process  (divided  equally 
between  the  periods,  or  proportionally  divided  according  to  the 
amount  of  each  amortisation),  or  if  small  it  may  be  disposed  of 
wholly  in  the  first  amortisation  so  as  to  leave  a  simple  schedule  for 
the  rest  of  the  duration  of  the  bond.  Thus  with  the  bond  discussed 
above  if  the  price  paid  was  $209,000.00,  instead  of  $208,982.59, 
assuming  a  market  quotation  of  104!,  a  residue  of  $17.41  must  be 
amortised.  This  might  be  added  to  the  first  amortisation,  giving 
$837.76  and  thereafter  a  straight  table  at  4%;  or  the  $17.41  might 


PRINCIPAL  AND   INTEREST  IN   VALUATIONS  185 

be  divided  into  ten  equal  parts,  giving  $1.74  to  be  added  to  each 
semiannual  amortisation ;  or,  to  be  exact,  we  might  divide  our  total 
amortisation,  $8982.59,  by  our  residue,  $17.41,  and  add  to  each  semi- 
annual amortisation  its  proportion  according  to  its  size,  i.  e.,  for 
the  first,  8982.59  :  820.35  ••  i7-4i  •  ^-  ^  method  of  finding  the  exact 
market  basis  on  the  assumption  of  a  fixed  rate  for  reinvestments  will 
be  found  in  Appendix  F,  page  428. 

We  have  now  remaining  the  important  question  of  the  treatment 
of  amortisation  when  the  income  belongs  to  one  person  and  the 
principal  to  another.  This  is  Ukely  to  happen  in  the  case  of  a  trustee 
who  is  to  administer  a  fund  in  such  a  way  that  one  heir  is  to  receive 
the  income  of  the  trust  for  his  Hfe  and  then  the  principal  is  to  be 
turned  over  to  another  heir.  Let  us  suppose,  in  order  to  make  our 
case  simple,  that  the  trust  fund  is  wholly  invested  in  the  bond  which 
we  have  been  examining.  How  much  shall  the  trustee  pay  annually 
to  the  person  holding  the  hfe  interest?  Clearly,  if  the  trustee  pays 
the  life-man  too  much  in  any  year,  unless  it  be  recompensed  in  later 
years,  the  remainder-man,  at  the  death  of  the  other,  will  receive  a 
principal  which  has  been  impaired;  but,  on  the  other  hand,  if  the 
trustee  gives  the  Ufe-man  too  little,  the  remainder-man  inherits  what 
the  life-man  should  have  reaHzed  during  his  Hfetime.  It  is  the  trus- 
tee's business  to  see  that  each  gets  his  exact  share. 

The  interest  on  the  bond  is  $5000  per  half-year,  2j%  on  $200,- 
000 ;  but  if  the  Hfe-man  is  given  this  $5000  each  half-year  and  chances 
to  live  exactly  until  the  bond  matures  and  no  longer,  the  remainder- 
man will  inherit  only  the  principal  of  the  bond,  or  $200,000,  al- 
though the  estate  was  originally  $208,982.59.  In  other  words,  the 
life-man  has  been  given  $8982.59  of  principal,  although  he  was  en- 
titled to  nothing  but  income.  The  real  income,  therefore,  is  not 
$5000  each  half-year,  but  the  interest  less  a  certain  annual  propor- 
tion of  the  premium,  or  the  amortisation. 

A  device  obvious  and  easy,  though  not  necessarily  quite  just  to 
both  parties,  is  to  pay  the  life  beneficiary  4%  on  the  original  invest- 
ment, which  was  $208,982.59,  or  $4179.65  each  half-year,  and  to 
put  the  annual  amortisation,  received  out  of  each  interest  payment 
of  $5000,  at  interest  to  accumulate  for  the  remainder-man. 

This  would  work  out  in  an  interesting  way. 


1 86 


ACCOUNTS 


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PRINCIPAL  AND   INTEREST  IN  VALUATIONS  1 87 

At  the  close,  the  face  of  the  bond,  $200,000,  is  paid,  and  the  sink- 
ing fund  amounts  to  $8982.59,  —  the  two  yielding  $208,982.59,  the 
original  investment,  preserved  for  the  life-man. 

This  looks  admirable  and  is  so  if  it  works.  The  only  doubt  about 
it  is  the  earnings  of  the  sinking  fund.  The  remainder-man's  share 
is  secured  to  him  through  this  agency,  and  it  may  happen  that  the 
amortisation  cannot  always  be  reinvested  immediately,  and  it  may 
not  always  be  possible  to  invest  these  small  amounts  in  a  safe  form 
at  this  rate  of  interest.  It  is  likely,  therefore,  that  this  fund  will  not 
increase  so  rapidly  as  has  been  assumed  in  this  case.  Then  the  re- 
mainder-man when  he  inherits  will  find  the  principal  impaired.  This 
scheme,  then,  though  theoretically  excellent,  is  not  always  practi- 
cally sound,  for  a  sinking  fund  is  not  always  trustworthy  when 
exact  justice  between  two  parties  rests  upon  its  regularity  of  in- 
come. 

It  is  evident  that  the  thing  must  be  worked  out  on  a  somewhat 
different  basis.  This  is  easily  furnished  by  the  original  amortisation 
schedule  given  on  page  171.  We  must  first  recognize  that  there  are 
two  separate  sorts  of  income  in  a  plan  of  this  kind.  The  first  is  the 
bond  interest,  and  the  second  is  the  interest  on  the  amortisation. 
The  bond  interest  is  certain,  because  it  is  determined  by  contract,  in 
the  terms  of  the  bond  itself ;  but  the  second  element  is  uncertain,  for, 
as  has  been  stated,  it  perhaps  cannot  always  be  invested  at  once  or  at 
the  rate  which  has  been  assumed  in  working  out  the  schedule.  The 
life-man  is  entitled  to  the  earnings  of  the  original  investment,  but 
after  the  first  six  months  the  original  investment  is  not  all  in  the 
bond,  for  a  part  of  it  has  been  returned  to  the  trustee,  that  is,  $820.35. 
The  life-man,  consequently,  is  entitled  to  4%  on  what  is  left  of  the 
bond  —  that  is,  4%  on  its  new  book  value,  —  and  he  is  entitled,  in 
addition,  to  what  can  be  earned  by  the  amortisation  fund.  In  other 
words,  it  is  not  the  remainder-man  that  should  suffer  from  a  low 
present  rate  of  interest  on  reinvestments  (for  he  is  entitled  to  the 
original  investment),  but  the  life-man.  We  must  then  use  our 
amortisation  table  as  given  on  page  171  and  with  that  as  a  guide 
give  the  life-man  4%  on  the  book  value  and,  in  addition,  all  the 
earnings  of  the  reinvestment  of  amortisation.  This  will  work  out 
as  follows : 


i88 


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PRINCIPAL  AND  INTEREST  IN  VALUATIONS  189 

If,  now,  we  compare  this  plan  with  the  other,  we  shall  find  the 
results  identical.  The  difference  between  the  two  tables  Hes  in  the 
fact  that  here  the  Hfe-man's  share  is  dependent  on  the  earnings 
of  the  amortisation,  as  it  should  be  —  since  he  is  entitled  to  income 
only,  —  and  the  remainder-man's  share  is  taken  from  the  fixed 
bond  interest,  as  it  should  be  —  since  he  has  nothing  to  do  with 
the  fluctuations  of  interest  earnings  but  has  a  right  to  demand 
that  the  premium  shall  be  kept  intact  for  him.  If  the  amortisa- 
tion fund  does  not  earn  the  4%  assumed  here,  this  plan  puts  the 
loss  on  the  right  man  —  the  man  entitled  to  earnings,  the  Hfe-man, 
—  whereas  the  other  plan  put  it  on  the  man  concerned  only  with 
the  preservation  of  capital,  the  remainder- man.  This  scheme  is 
perfect. 

This  is  so  clearly  fair  that  it  seems  hardly  necessary  to  dwell  on 
any  other  plan,  but  another  sometimes  resorted  to  is  so  obvious 
and  so  easy  that  it  has  proved  decidedly  dangerous,  —  in  fact  has 
been  upheld  in  a  number  of  courts  where  cases  of  this  sort  have 
come  before  a  judge.  This  divides  the  total  amount  of  premium, 
that  is,  the  total  shrinkage  of  principal  to  be  suffered,  by  the  num- 
ber of  interest  payments  and  subtracts  the  quotient  from  each  in- 
terest payment.  That  is,  it  distributes  the  total  amortisation  equally 
among  the  periods  that  the  bond  has  to  run,  and  gives  the  life- 
man  the  earnings  of  the  amortisation  fund.  It  thus  provides  for 
the  total  shrinkage  and  leaves  the  principal  intact  for  the  remainder- 
man; and  so  far  it  is  good.  Unfortunately,  however,  it  does  this 
fairly  only  in  the  end  and  not  year  by  year.  If  the  life- man  should 
die  before  the  expiration  of  the  Hfe  of  the  bond,  the  principal  would 
be  found  to  be  increased,  and  he  would  have  received  less  than  his 
due.  This  will  be  seen  by  comparing  the  life-man's  yearly  share  as 
given  in  the  last  table  with  his  yearly  share  under  the  plan  proposed. 
If  the  total  amortisation  or  premium  is  divided  equally  among  the 
half-year  periods,  the  amortisation  for  each  period  is  $898.26,  and 
the  life-man's  share  of  bond  interest  is  $4101.74  ($5000.00  — $898.26). 
In  the  first  period  this  is  his  total  receipt,  for  no  interest  has  been 
earned  by  the  amortisation  fund.  In  the  second  and  all  subsequent 
periods  the  bond  interest  will  be  the  same,  but  the  income  of  the 
amortisation  fund  will  be  increasing.  Our  last  table  showed  the 
life-man's  share  to  be  $4179.65  in  the  first  period,  and,  on  the  as- 


I90  ACCOUNTS 

sumption  that  the  amortisation  fund  can  earn  4%,  for  all  subsequent 
periods.  In  the  plan  just  outlined,  on  the  other  hand,  we  find  the 
life-man's  share  to  be  $4101.74+  $17.97  (interest  on  the  amortisation 
fund)  in  the  second  period,  and  so  on  slowly  increasing  until  in  the 
tenth  period  it  is  $4101.74+ $161.68  (interest  on  accumulations  of 
the  amortisation  fund  for  nine  periods),  or  $4263.43  in  all.^  He  is 
thus  receiving  far  too  Httle  in  the  earlier  periods  and  far  too  much 
in  the  later.  What  he  loses  in  earlier  years  is  made  up  in  the  later, 
to  be  sure,  if  he  lives ;  but  he  is  entitled  to  the  income  for  his  life, 
and  if  a  part  of  this  income  is  held  back,  in  the  expectation  that  it 
will  be  offset  later,  and  he  dies,  justice  is  not  done.  The  reason  of 
this  failure  to  do  justice  is  simply  that  in  this  case  not  sufficient 
allowance  has  been  made  to  the  Hfe-man  in  early  periods  for  accu- 
mulations of  the  amortisation  fund.  It  is  right  that  each  period 
should  give  up  from  bond  interest  a  sum  which  at  the  end  of  the 
time  will  amount  to  one  tenth  of  the  premium ;  but  this  does  not  need 
to  be  so  much  in  early  years  as  in  later,  for  compound  interest  must 
be  allowed.  To  enlarge  the  fund  in  early  years  at  his  expense  is  to 
run  the  risk  that  he  will  not  hve  to  receive  what  has  been  borrowed 
from  him.^ 

*  The  full  table  under  this  plan  would  be  as  follows : 


Date 

Bond 
Interest 

Amorti- 
sation 

Net 
Interest 

Total 
Amorti- 
sation 
Fund 

Inter- 
est on 
Fund 

Total 
Income 
of  Life- 
Man 

Book  Value 

08  Jan.  I 

-      - 

-       - 

-       - 

-       - 

-      - 

_       _ 

$208,982.59 

July  I 

$5,000.00 

$898.26 

$4,101.74 

$898.26 

-     - 

$4,101.74 

208,084.33 

09  Jan.  I 

5,000.00 

898.26 

4,101.74 

1,796.52 

$17-97 

4,119-71 

207,186.07 

July  I 

5,000.00 

898.26 

4,101.74 

2,694.78 

35-93 

4,137-67 

206,287.81 

10  Jan.  I 

5,000.00 

898.26 

4,101.74 

3»593-04 

53-89 

4,155-63 

205,389-55 

July  I 

5,000.00 

898.26 

4,101.74 

4,491.30 

71.86 

4,173.60 

204,491.29 

II  Jan.  I 

5,000.00 

898.26 

4,101.74 

5,389-56 

89.83 

4,191-57 

203,593-03 

July  I 

5,000.00 

898.26 

4,101.74 

6,287.82 

107.79 

4,209.53 

202,694.77 

12  Jan.  I 

5,000.00 

898.26 

4,101.74 

7,186.08 

125.76 

4,227.50 

201,796.51 

July  I 

5,000.00 

898.26 

4,101.74 

8,084.34 

143-72 

4,245.46 

200,898.25 

13  Jan.  I 

5,000.00 

898.25 

4,101.75 

8,982.59 

161.68 

4,263.43 

200,000.00 

'  The  total  receipts  of  the  life-man  under  this  plan  are  of  course  greater  than  under 
the  other  plans  discussed,  for  in  this  case  he  receives  interest  on  the  postponement 
of  his  true  share  of  the  income;  but  he  naturally  would  prefer  to  receive  the  princi- 
pal of  his  true  share  rather  than  to  have  it  withheld  and  compensated  by  an  interest 
payment  —  especially  if  he  is  to  die  and  his  estate  is  to  lose  the  interest. 


PRINCIPAL   AND    INTEREST   IN   VALUATIONS         I9I 

Numerous  other  complications  sometimes  arise  in  connection 
with  allowance  for  interest  and  discount,  but  the  principles  have 
been  covered  in  the  illustrations  given  above/ 

It  is  to  be  noted  that  the  principles  discussed  in  this  chapter  are 
appHcable  not  only  to  bonds,  but  also  to  leases,  royalties,  copy- 
rights, dowers,  insurance  premiums,  etc.  Wherever  time  enters 
into  a  claim,  the  valuation  is  dependent  on  interest  or  discount.  If, 
for  example,  a  lease  binds  a  lessee  to  pay  more  than  the  market 
rate  on  the  property  leased,  it  is  a  claim  to  an  annuity  for  the  owner 
of  the  property;  if  it  binds  the  owner  to  less  than  the  market  rate, 
it  practically  secures  an  annuity  to  the  lessee.  Suppose  a  tenant 
holds  a  lease  for  twenty  years  on  a  buildmg  at  an  annual  rental  of 
$10,000,  and  at  the  end  of  ten  years  the  property  has  become  too 
valuable  for  the  tenant's  business  and  he  sublets  the  building  at  a 
fair  rental.  The  value  of  the  lease  should  appear  on  his  books  and 
should  be  annually  amortised.  Assuming  the  building,  because  of 
changes  in  business  demand,  to  be  worth  now  $15,000  a  year  and 
on  the  first  day  of  the  eleventh  year  to  be  let  for  that,  ownership  of 
the  lease  brings  to  the  former  tenant  a  clear  gain  of  $5000  a  year 
(excess  of  rent  received  over  rent  paid).  The  value  of  the  lease,  then, 
at  the  beginning  of  the  sub-lease  is  the  value  of  an  annuity  of  $5000 
for  ten  years.  At  5%  this  is  $38,608.67.  If  rental  were  paid  quar- 
terly, the  value  would  be  that  of  an  annuity  of  $1250  for  forty 
periods  discounted  at  i|%  per  quarter,  or  $39,158.67.  Yet  this 
value  cannot  be  counted  as  an  asset  continuously.  It  will  wholly 
disappear  in  ten  years,  —  a  portion  each  year.  Each  year  enough 
should  be  taken  out  of  the  rental  received  to  amortise  it.  If  this 
deduction  is  put  into  a  sinking  fund,  it  will  accumulate  with  inter- 
est to  the  value  of  the  lease  as  above.  The  amount  is  as  a  matter 
of  fact  (taking  the  first  figure  above)  $3069.57  of  the  $5000  re- 
ceived on  the  lease.  The  balance,  or  $1930.43,  is  exactly  the  year's 
interest  on  the  value  of  the  lease.  In  other  words,  the  value  added 

1  An  excellent  work  on  this  subject  is  Professor  Charles  Ezra  Sprague's  Account- 
ancy  of  Investment.  This  gives  many  illustrations  of  the  points  covered  here,  and 
discusses  several  complex  cases  that  would  be  rather  out  of  place  in  a  general  treatise 
of  this  sort.  In  connection  with  Professor  Sprague's  book  are  published  elaborate 
interest  and  bond  tables. 

Formulae  for  the  determination  of  interest,  amount,  present  worth,  compound 
discount,  etc.,  will  be  found  in  Appendix  F,  herein. 


192  ACCOUNTS 

to  the  lease  by  the  demand  for  real  estate  is  a  capital  gain,  and, 
if  it  is  not  to  be  consumed,  it  must  be  preserved  intact  by  reserv- 
ing from  the  rent  enough  to  accumulate,  at  the  expiration  of  the 
lease,  to  its  original  value.  This  leaves  for  income  only  interest  on 
the  capital  value  —  which  is,  of  course,  as  it  should  be. 

It  is  now  time  to  observe  the  method  by  which  amortisation  and 
accumulation  are  registered  upon  books  of  account.  In  corporations 
holding  large  numbers  of  bonds  it  would  be  obviously  a  tremendous 
waste  of  labor  to  make  a  journal  entry  for  each  amortisation  in  each 
holding  of  bonds.  The  amortisation  or  accumulation  for  each  hold- 
ing is  shown  in  detail  on  a  special  bond  ledger,  kept  as  a  subordinate 
ledger  represented  by  an  account  in  the  general  ledger,  and  the 
total  amortisation  and  accumulation  are  then  entered  through  the 
journal  upon  the  general  ledger.  Since  amortisation  and  accumula- 
tion are  usually  identified  with  interest,  the  natural  entry  is  in  con- 
nection with  some  interest  account.  Before  providing  for  entries 
of  amortisation  and  acciunulation,  therefore,  we  must  see  how  inter- 
est is  to  be  entered. 

Good  bookkeeping  in  businesses  where  interest  is  a  large  item 
requires  that  three  sorts  of  interest  shall  be  recognized  and  distin- 
guished, —  interest  accrued,  interest  earned,  interest  due.  The 
distinction  between  these  three  classes  may  be  suggested  by  a  con- 
crete case.  If  you  buy,  on  August  i ,  a  bond  bearing  interest  payable 
in  November  and  in  May,  you  have  on  that  bond  on  the  day  of  pur- 
chase no  interest  earned,  for  you  have  not  earned  any  interest  upon 
that  bond  on  the  day  on  which  it  is  bought.  You  have,  however,  some 
interest  accrued,  for  you  have  bought  from  the  former  holder  interest 
accrued  between  May  i  and  August  i.  You  have,  again,  no  interest 
due,  for  your  claim  is  not  enforceable  until  November  i .  The  pur- 
pose of  the  distinction  between  these  three  classes  of  interest  is,  then, 
sufficiently  obvious.  To  Interest  Earned  is  carried  only  the  actual 
earnings  of  interest  while  the  investment  is  in  the  hands  of  the  busi- 
ness. Interest  which  lapse  of  time  has  made  a  good  claim  of  the 
business,  though  not  yet  an  enforceable  claim,  is  carried  to  Interest 
Accrued.  Interest  on  which  a  claim  may  now  be  enforced  is  entered 
to  Interest  Due.  Changes  in  the  relation  between  these  three  sorts 
of  interest  must  go  into  the  general  ledger  and  hence  entries  will  be 
made  through  the  general  journal. 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS         I93 

Now  let  us  illustrate  interest  and  amortisation  in  the  case  given 
above.  On  the  day  of  purchase,  if  we  buy  above  par,  we  buy  three 
things:  a  claim  to  interest  accrued  since  May  i ;  a  claim  to  the  par 
value  of  the  bond ;  and  a  claim  to  interest  payments,  from  August  i 
until  the  maturity  of  the  bond,  at  something  higher  than  the  market 
rate  (else  we  should  not  have  paid  a  premium).  The  claim  for  ac- 
crued interest  will  become  enforceable  November  i ;  the  claim  for 
the  par  value  will  be  enforceable  perhaps  in  the  distant  future ;  the 
claim  for  excess  interest  will  be  enforceable  at  regular  intervals,  and, 
of  course,  when  each  portion  is  paid  the  balance  remaining  will  be 
less,  —  that  is,  this  claim  must  be  amortised. 

Our  first  entry  will  be 

[il 
Bonds 

Interest  Accrued 
To  Cash 

On  November  i,  our  entries  must  allow  for  amortisation,  for  ac- 
crued interest,  for  earned  interest,  for  due  interest,  and  for  the  pay- 
ment of  interest  if  payment  is  made ;  thus : 

[2] 
Interest  Accrued 

To  Interest  Earned 

[Interest  between  August  i  and  November  i.  Interest  accrued  was  deb- 
ited for  three  months'  interest  when  the  bond  was  bought,  and  it  is  now 
debited  for  that  of  the  second  three  months.  Thus  the  books  show  a 
proper  resource.] 

(31 

Interest  Due 

To  Interest  Accrued 
[Interest  between  May  i  and  November  i.  This  transfers  the  resource 
from  the  accrued  to  the  due  account.] 

I4l 

Interest  Earned 

To  Amortisation 
[To  show  the  amount  deducted  from  bond  interest  for  amortisation  of 
premium.] 

isl 

Amortisation 

To  Bonds 
[To  show  the  shrinkage  in  bond  value  and  close  out  Amortisation.1 


194  ACCOUNTS 

Then,  if  the  interest  is  paid, 

16] 
Cash 

To  Interest  Due 
[This  closes  the  Interest  Due,  so  far  as  this  bond  is  concerned,] 

Finally,  if  the  amortisation  is  reinvested  or  set  aside, 

[71 

Amortisation  Fund 
To  Cash 

Many  variations  from  these  entries  are  possible.  For  example,  the 
fourth  entry  might  be  omitted  by  incorporating  it  in  the  second,  reduc- 
ing the  amount  of  Interest  Earned  and  adding  Amortisation  as  a 
credit  item ;  or  we  could  even  substitute  Bonds  for  Amortisation  in 
this  corrected  second  entry  and  thus  omit  both  the  fourth  and  the 
fifth  entry.  These  entries  are  kept  here  because  it  is  desirable  to  show 
all  the  amounts,  and  since  such  entries  would  be  made  not  for  each 
holding  of  bonds,  but  in  totals  for  all  holdings  at  regular  intervals, 
the  extra  labor  is  not  to  be  considered.  Similarly,  Interest  Due  is 
maintained  here  in  spite  of  the  possibility  of  combining  the  third, 
sixth,  and  seventh  because  in  case  any  interest  is  defaulted  this  ac- 
count should  show  a  resource  balance. 

It  will  be  seen  that  Interest  Accrued  is  a  real  account,  representing 
claims,  and  hence  belonging  on  the  balance  sheet,  and  Interest 
Earned  is  a  nominal  account,  representing  revenue,  and  hence  be- 
longing on  the  income  sheet.  Notice  must  be  talien  of  the  fact  that 
interest  has  been  counted  up  to  the  beginning  of  the  new  year,  and 
hence  the  next  calculation  of  interest  must  be  from  that  time  only. 
In  some  offices,  interest  accruments  and  earnings  are  figured  and 
entered  daily,  and  amortisation  and  interest  due  are  entered  at 
all  interest  dates.  Of  course  these  entries  are  made  in  totals  only, 
from  sheets  prepared  especially  for  that  purpose. 

The  treatment  of  accumulation  is  shghtly  different  from  that  of 
amortisation.  Here  a  part  of  the  interest  on  the  investment  is 
postponed,  for  since  the  bond  sells  at  a  discount  on  account  of  low 
interest,  the  deficiency  in  interest  is  to  be  made  up  only  at  the  matur- 
ity of  the  bond,  —  when  the  par  value  (more  than  the  cost  price) 
will  be  paid.  Theoretically,  therefore,  the  accumulation  should  be 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  I95 

added  not  only  to  the  book  value  on  the  bond  account,  but  also 
to  Interest  Accrued  and  Interest  Earned.  Only  at  maturity  of  the 
bond  does  it  become  Interest  Due.  The  accumulation  account, 
meantime,  measures  how  much  of  accrued  and  earned  interest  is  to 
offset  discount  on  bonds. 

In  cases  of  trusteeship  with  one  person  entitled  to  income  and 
another  to  principal,  this  accumulation  is  likely  to  cause  trouble. 
Strictly  speaking,  the  full  income  cannot  be  delivered  periodically, 
for  a  part  is  locked  up  in  the  bond.  It  is  essential,  therefore,  that 
the  accumulation  shall  be  exactly  recorded,  so  that  delivery  may 
be  made  at  the  maturity  of  the  bond.  In  case  of  the  death  of  the 
life-man  before  maturity  of  the  bond,  the  accumulation  recorded  for 
the  time  of  death  belongs  properly  to  his  estate  —  for  it  is  income 
accumulated  during  his  life,  even  though  the  claim  be  not  enforce- 
able until  long  after  his  death.  The  demand  sometimes  made  that 
this  accumulation  shall  be  converted  into  cash,  or  shall  be  redeemed 
from  other  funds  belonging  to  the  estate,  can  hardly  be  maintained 
with  reason  if  the  bequest  specifies  the  property.  In  such  a  case,  the 
remainder-man  is  entitled  to  that  specific  property,  and  it  should  not 
be  impaired.  The  life-man  is  entitled  to  the  income  only,  and  that 
income  can  be  claimed  only  as  fast  as  it  becomes  payable.  If,  on 
the  other  hand,  the  bequest  is  in  general  terms,  the  life-man  may 
justly  complain  if  the  funds  are  locked  up  in  bonds  realizable  only 
after  accumulation. 

It  is  not  always  easy  to  learn  whether  profit  or  loss  has  occurred 
on  bonds  or  other  investment  sold,  nor  are  the  exact  entries  to  make 
for  purchase  and  sale  always  obvious.  This  is  due  partly  to  the 
fact  that  bonds  are  usually  bought  at  *' round"  prices,  and  partly 
to  the  fact  that  they  are  usually  bought  between  interest  dates, 
sometimes  " and  interest "  and  sometimes  ''flat."  The  round  price 
almost  never  fits  the  exact  theoretical  price,  for  market  quotations 
are  in  eighths  of  one  per  cent.,  so  that  the  nearest  quotation  for 
bonds  worth  $10,181.25  would  be  loif  or  ioi|  ($10,175.00  or  $10-, 
187.50),  either  of  which  misses  the  theoretical  value  by  $6.25,  and 
yet  the  theoretical  value  is  most  convenient  to  take  into  the  ac- 
counts so  that  amortisation  will  work  out  smoothly.  Such  differ- 
ences may  well  be  carried  in  an  account  called  ''Bond  Price  Resi- 
dues."   When  the  price  is  "flat,"  and  it  is  then  also  "round" 


196  ACCOUNTS 

(though  in  ordinary  speech  this  would  be  a  contradiction  in  terms), 
a  round  price  is  paid  to  include  the  accrued  interest,  whereas  when 
the  price  is  quoted  as  "and  interest"  (always  understood  when 
nothing  is  specified)  the  accrued  interest  is  added  to  the  quotation. 
Suppose,  for  illustration,  the  bonds  referred  to  on  page  179,  as 
bought  on  Feb.  i,  1908,  had  been  bought  at  a  quotation  of  104! 
"and  interest."  As  the  bond  interest  for  one  month  on  $200,000 
is  $833.33,  the  price  would  have  been  $209,583.33  ($200,000  @ 
1.04I  =  $208,750  for  the  bonds;  this  +  $833.33  ^^r  accrued  interest 
=  $209,583.33  total  price).  This  $208,750,  however,  will  not  match 
our  amortisation  table,  for  in  that  we  used  a  4%  basis.  The  residue, 
of  $95.87,  will  be  a  credit,  therefore,  to  "Bond  Price  Residues"  — 
unless,  indeed,  we  wish  to  distribute  it  as  suggested  on  page  184. 
Our  entry  will  be 

Bonds  $208,845.87 

Interest  Accrued  833.33 

To  Cash  $209,583.33 

Bond  Price  Residues  95.87 

If,  on  the  other  hand,  this  bond  had  been  sold  "flat,"  the  nearest 
round  price  to  our  theoretical  value  would  have  been  104I,  or 
$209,750;  for  since  the  flat  price  includes  interest  amounting  to 
$833.33,  the  amount  remaining  for  the  bond  proper  would  have 
been  $208,916.67,  and  this  comes  within  $70.80  of  the  $208,845.87 
on  our  amortisation  table.  Our  entry,  then,  is 

Bonds  $208,845.87 
Interest  Accrued  ^33-33 

Bond  Price  Residues  70.80 

To  Cash  $209,750.00 

If  current  interest  is  recorded  month  by  month,  an  entry  will  be 
made  on  the  first  of  each  of  the  following  five  months  as  follows: 

Interest  Accrued  $833.33 

To  Interest  Earned  $833.33 

On  July  I  correction  must  be  made  for  the  amortisation,  thus: 

Interest  Earned  $683.63 

To  Amortisation  $683.63 

and  the  interest  due  must  be  entered,  thus: 

Interest  Due  $5000 

To  Interest  Accrued  $5000 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS  I97 

When  Amortisation  is  closed  to  Bonds,  the  book  value  of  the 
bonds  is  $208,162.24,  no  accrued  interest  is  left  on  the  books,  and 
earned  interest  is  shown  to  be  S3483.04.  These  figures  agree  with 
oxir  table  on  page  180. 

If  the  bonds  are  sold  on  September  i  for  104  and  interest,  they 
will  bring  $209,666.67  ($208,000 +  $1666.67),  but  if  sold  for  104! 
flat  they  will  bring  $209,500.  The  theoretical  price,  based  on  the 
amortisation  table,  is  $209,549.99  ($208,162.24,  the  July  value, 
less  I  the  next  amortisation,  or  $278.92,  plus  the  accrued  interest, 
or  $1666.67).  I^  either  case  we  have  a  residue.  Before  entering 
the  sale  we  should  bring  the  bonds  to  date  on  our  books  as  follows: 

Interest  Accrued  $1666.67 

To  Interest  Earned  $1387.75 

Bonds  [or  Amortisation]  278.92 

This  interest  earned,  it  should  be  noted,  is  just  the  basis  rate 
(4%  a  year,  or  |  of  1%  for  two  months)  on  the  July  i  book  value. 
The  amortisation  brings  the  bonds  to  $207,883.32. 

Our  last  entry  will  be  one  of  the  following  —  according  as  the 
bonds  were  sold  "and  interest"  or  "flat.'' 

I  II 

Cash                  $209,666.67  Cash                  $209,500.00 

To  Interest  Accrued              $     1,666.67  Bond  Price  Residue    49.99 

Bonds                                207,883.32  To  Interest  Accrued     $     1,666.67 

Bond  Price  Residue                 116.68  Bonds                        207,883.32 

Bond  Price  Residues  is  really  an  explanation  of  capital  gains  and 
losses,  for  residues  are  matters  of  chance  not  affected  by  business 
operations;  theoretically  they  should  be  closed  into  Capital  Sur- 
plus; but  as  the  amounts  are  always  comparatively  small  they  may 
as  well  go  as  revenue  balances  —  except,  of  course,  in  cases  of  trust 
in  which  the  distribution  between  life-man  and  remainder-man 
must  be  guarded. 

In  the  case  worked  out  above  no  profit  or  loss  was  involved  in  the 
sale  except  that  due  to  small  price  residues.  Yet  the  bonds  were 
sold,  after  allowing  for  the  difference  in  accrued  interest,  for  much 
less  than  they  cost.  In  the  case  of  the  price  "and  interest,"  the 
shrinkage  was  $750;  in  the  other,  $1083.34.  To  conclude  that  this 
shrinkage  is  loss  would  be  to  confuse  capital  and  revenue;  for  the 
shrinkage  was  made  up  by  the  higher  rate  of  interest  received 


198  ACCOUNTS 

while  the  bonds  were  held.  The  rate  received  was  5%,  but  the  basis 
was  4%.  The  excess  was,  of  course,  premium  returned,  or  capital 
restored.  Only  when  one  comes  to  work  out  the  return  of  inter- 
est by  allowing  for  amortisation  or  accumulation  can  one  learn 
whether  the  apparent  loss  or  gain  on  the  shrinkage  or  appreciation 
of  bonds  was  real  or  not. 

The  large  difference  between  the  shrinkages  in  the  two  cases 
considered  above,  one  at  a  price  *'and  interest"  and  the  other  at  a 
flat  price,  is  due  to  the  fact  that  in  one  case  gain  happened  to  be 
made  on  both  ends,  buying  below  the  theoretical  price  and  selling 
above  it,  and  in  the  other  loss  happened  at  both  ends.  This  is  pure 
chance,  for  the  residue  will  happen  as  often  one  way  as  the  other 
on  either  sort  of  quotation. 

Often,  of  course,  prices  change  so  much  in  the  market  that  a  large 
real  loss  or  gain  is  made  on  bond  sales.  In  that  case,  other  people's 
present  estimates  of  a  fair  basis  or  market  rate  is  different  from 
that  on  which  the  bonds  were  originally  bought.  That  investors 
are  not  always  agreed  as  to  what  should  be  the  basis  rate  is  evi- 
denced by  the  wide  variation  in  bids  sometimes  made  for  National, 
State,  and  municipal  bonds.  In  a  recent  city  issue,  where  the  credit 
was  good,  bids  ran  all  the  way  from  104  down  to  loi.  Careful  bid- 
ders evidently  figured  exactly  what  they  were  willing  to  pay,  for 
some  bids  ran  to  four  places  of  decimals  —  e.g.,  101.4276.  This 
gives  the  nearest  mill,  $1,014,276,  for  a  bond  for  $1000.  This  bid 
gave  a  basis  rate  of  3.91%.  If  bonds  were  sold  on  the  market  by 
quotations  as  exact  as  this,  few  residues  would  remain  either  to  be 
distributed  over  the  amortisation  or  to  be  carried  over. 

So  far  we  have  considered  interest  obligations  from  the  point  of 
view  of  the  investor.  The  issuer  of  such  obligations  sometimes  gets 
into  difficulty  because  of  confusion  in  his  accounts.  Suppose  a  rail- 
road issues  $10,000,000  of  bonds,  payable  in  forty  years,  paying 
interest  at  5  %  in  semi-annual  installments.  The  public  faith  in  the 
road  is  not  on  a  5%  basis,  but  thinks  5^%  should  be  paid.  The 
bonds  will  then  sell  at  a  discount,  and  will  be  worth  (theoretically) 
$9,194,676.48.  If  the  bonds  are  taken  at  92,  the  road  will  get 
$9,200,000.  The  obligation  of  $10,000,000  must  appear  among  its 
liabilities,  of  course,  and  only  $9,200,000  in  cash  can  appear  as  an 
asset.  The  other  $800,000  is  what?  It  cannot  be  charged  as  a  loss, 


PRINCIPAL  AND   INTEREST  IN  VALUATIONS         1 99 

for  the  road  has  lost  nothing,  and  hence  it  must  be  an  asset.  What 
is  the  asset?  It  is  the  privilege  of  using  $io,ocx),ooo  at  an  interest 
rate  of  5  %  when  the  market  rate  is  5I  %.  This  is  an  asset  just  as  the 
lease  previously  discussed  is  an  asset.  The  $800,000,  or  theoreti- 
cally $805,323.52,  is  the  present  worth  of  an  annuity  for  40  years  of 
the  difference  in  interest  between  5%  and  5^%,  and  should  appear 
on  its  balance  sheet  as  Bond  Discount.  Six  months  later,  however, 
that  asset  will  be  partly  consumed  and  must  be  written  off.  What 
shall  be  charged?  The  road  has  been  paying  nominally  5%  interest, 
but  it  is  in  effect  paying  5^%,  or  must  ultimately  do  the  equivalent. 
So  interest  should  be  charged  for  the  amount  necessary  to  take 
care  of  that  difference.  The  additional  entry  then  at  the  time  of  the 
first  interest  payment  is  this: 

Interest  $2,853.60  ^ 

To  Bond  Discount  $2,853.60 

The  interest  will  appear  among  the  interest  charges  on  the  income 
sheet  and  the  Bond  Discount  will  be  reduced  on  the  balance  sheet. 
As  the  road  deducts  this  amount  from  income,  counting  it  as  a 
cost,  it  thereby  accumulates  a  fund  (though  not  necessarily  spe- 
cially set  aside)  to  offset  the  discount  originally  suffered. 

If,  on  the  other  hand,  the  bonds  had  borne  6%  interest  and  the 
public  had  deemed  5^%  enough,  the  bonds  would  have  brought 
theoretically  $10,805,323.52,  or  a  premium  of  $805,323.52.  Sup- 
posing the  sale  was  at  108,  this  would  have  been  entered  as  follows: 

Cash  $10,800,000 

To  Bonds  $10,000,000 

Premium  on  Bonds  800,000 

This  premium  would  be  a  liability,  but  decreasing  each  year  as 
the  contract  to  pay  extra  interest  is  fulfilled,  and  each  year  the 
interest  charges  would  be  reduced,  below  the  figure  actually  paid, 
by  an  entry  showing  how  much  of  the  payment  had  liquidated  the 
debt  incurred  by  selling  at  a  premium  the  bonds  issued.  The  first 
entry  for  reducing  both  interest  charges  and  bond  premium  follows: 

Bond  Premium  $2853.60 

To  Interest  $2853.60 

*  This  figure  looks  very  small  for  the  total  amount  to  be  covered;  but  as  the  term 
of  the  bonds  is  long  the  increase  is  large.  In  the  last  six  months  the  amount  is  $24,- 
330.90.  The  Interstate  Commerce  Commission  requires  that  this  amortisation  be 
carried  in  a  separate  account  distinct  from  bond  interest. 


200  ACCOUNTS 

In  the  last  six  months  the  amount  for  this  entry  will  be  $24,330 
.90.  The  result  of  this  growth  in  the  amount  of  periodic  amortisa- 
tion is  a  steady  reduction  in  the  amount  of  interest  charges,  though 
there  is  no  reduction  in  the  bond  interest  paid.  This  is  right,  of 
course,  for  the  company  has  each  year  less  of  its  creditors'  money 
—  because  the  premium  is  gradually  paid  back.  The  reverse  is 
true  when  the  bonds  were  sold  at  a  discount;  for  then  the  company 
holds  more  and  more  of  its  creditors'  money  —  accumulated  defi- 
ciencies of  interest,  or  sums  by  which  interest  actually  paid  in  the 
past  has  been  below  a  fair  (basis)  rate  for  the  use  of  money. 

Of  late  years  obligations  of  a  type  apparently  more  complicated 
than  those  previously  discussed  have  appeared  on  the  market  with 
increasing  frequency.  Such  are  serial  bonds  and  bonds  with  op- 
tional redemption.  These  involve  not  new  principles  but  new  ap- 
plications of  the  principles  already  discussed.  The  value  of  a  series 
of  serial  bonds,  for  example,  is  simply  the  sum  of  the  individual 
values  of  all  the  bonds  of  the  series;  and  hence  though  a  price  may 
be  quoted  for  the  series  it  may  be  in  reality  not  a  fair  price  for 
any  single  bond  but  only  an  average  price  for  all  the  bonds.  Serial 
bonds  are  commonly  issued  by  municipalities  and  State  govern- 
ments. As  they  mature  in  sequence,  usually  at  one-  or  two-year 
intervals,  the  debtors  pay  them  out  of  taxes  or  other  revenues  and 
avoid  the  awkwardness  of  accumulating  large  sinking  funds  for  the 
redemption  of  bonds  at  long  intervals.  A  city  may  borrow  for  street 
improvement,  for  example,  and  issue  a  series  of  bonds  with  five 
maturities,  two,  four,  six,  eight,  ten  years.  If  the  interest  is  semi- 
annual, the  city  makes  four  interest  payments  on  all  the  bonds  and 
then,  coincident  with  the  fourth  payment,  pays  the  principal  of 
those  first  maturing.  Coincident  with  the  fourth  succeeding  in- 
terest payment  (such  interest  payments  are  now  on  a  reduced  num- 
ber of  bonds)  it  redeems  those  with  the  second  maturity;  and  so 
to  the  end.  Since  the  payments  are  so  variable,  no  convenient  for- 
mula is  available  for  finding  by  one  calculation  the  value  of  the 
series. 

Optional  redemption,  by  which  the  issuer  of  bonds  retains  the 
right  to  redeem  them  earlier  than  natural  maturity  on  paying  a 
sum  different  from  par  (usually,  of  course,  larger,  so  as  to  make  the 
bonds  attractive),  involves  two  considerations  affecting  value.  If 


PRINCIPAL  AND  INTEREST  IN  VALUATIONS         20I 

the  market  conditions  are  such  (and  are  likely  to  continue  such) 
as  to  make  redemption  at  the  specified  time  and  rate  unprofitable 
for  the  issuer,  the  option  will  not  affect  the  value;  for  then  the  mar- 
ket price  will  be  lower  than  the  redemption  figure,  and  if  the  bonds 
have  been  amortised  (or  accumulated)  to  that  lower  figure,  only 
gain  will  arise  from  redemption  at  a  higher  figure;  so  for  such  bonds 
the  basis  rate  is  used  in  all  calculations  without  influence  by  the 
provision  for  optional  redemption.  If,  on  the  other  hand,  a  prob- 
abiHty  of  redemption  is  indicated  by  a  higher  theoretical  book 
value,  figured  on  the  natural  basis  rate,  than  that  involved  in  the 
optional  redemption,  it  is  necessary  to  assume  such  redemption,  to 
set  a  lower  value  on  the  bonds,  and  to  amortise  down  to  the  re- 
demption figure  by  the  time  specified  for  redemption;  in  figuring 
the  value  and  amortisation  of  bonds  to  be  so  redeemed,  however, 
it  is  necessary  to  remember  that  the  amount  to  be  received  at  re- 
demption, one  element  of  this  value,  is  not  the  par  of  issue  but  the 
redemption  figure,  and  that  the  annuity  of  interest  is  of  shorter 
term  than  that  nominally  specified. 

One  illustration  will  suffice.  A  bond  paying  5%,  in  semi-annual 
installments,  will  mature  in  twenty  years,  but  it  may  be  redeemed 
in  ten  years  at  103 J.  The  buyer  deems  4^%  a  fair  basis,  and  finds 
that,  assuming  no  redemption,  the  bond  is  now  w^orth  $10,654.84, 
and  will  be  worth  in  ten  years  $10,399.09.  Here,  then,  is  the  prob- 
ability of  redemption  —  a  saving  of  $49.09  to  the  company.  What, 
then,  is  the  bond  worth  at  the  time  of  issue  on  a  4^%  basis?  This 
may  be  figured  in  several  ways,  but  the  most  obvious  is  the  first 
method  shown  on  page  168  for  bonds  of  the  common  type.  The 
interest  each  six  months  will  be  $250.00.  Then, 

Present  worth  of  annuity  of  $250.00,  for  20  periods,  @  2l%  $3,990.93 

Present  worth  of  $10,350,  in  20  periods,  @  2\%  6,632.45 

Value  of  bond  $10,623.38 

In  other  words,  this  bond  is  worth  less,  because  of  the  probabil- 
ity of  optional  redemption,  by  $31.46,  though  the  saving  to  the 
company  is  $49.09.  The  difference  is  due  to  the  fact  that  $49.09 
payable  ten  years  hence  is  worth  only  $31.46  to-day  (at  4^%  com- 
pounded semi-annually).  This  value  will  amortise,  at  a  4^%  basis, 
to  $10,350  at  the  redemption  date.   If  then  redemption  does  not 


202  ACCOUNTS 

take  place,  a  gain  will  accrue  to  the  bond  owner,  for  a  bond  con< 
tinuing  to  pay  5%  on  a  4^%  basis  is  worth,  as  we  have  seen, 
$10,399.09. 

Bonds  are  occasionally  issued  with  two  rates  of  interest  —  one 
to  be  effective  after  the  expiration  of  the  other.  The  method  of 
valuation  is  suggested  by  previous  discussions.  In  case  5%  is  to  be 
paid  for  twenty  years  and  then  4^%  for  ten  years,  one  could  find 
the  value  by  dividing  the  obHgation  into  three  parts  and,  after 
valuing  each  separately,  adding  them  thus: 

Present  worth  of  principal  at  maturity 
Present  worth  of  5%  annuity  for  twenty  years 

Present. worth  of  41%  annuity  for  ten  years  beginning  twenty  years  hence 
Total 

The  value  of  the  last  element  would  be  found  either  by  subtracting 
the  present  worth  of  a  4^%  annuity  for  twenty  years  from  the 
value  of  a  similar  annuity  for  thirty  years,  or  by  adding  together 
the  present  worths  of  single  payments  of  the  proper  amounts  due 
in  twenty  years,  twenty  and  one  half  years,  twenty-one  years,  etc. 


CHAPTER  THIRTEEN 

THE   GENERAL   PRINCIPLES  OF   CAPITALIZATION 

In  Chapter  VII  the  distinction  between  charging  to  revenue  and 
charging  to  capital  was  indicated,  but  the  illustrations  were  of  a 
rather  obvious  type.  Now  that  our  general  discussion  has  proceeded 
further,  it  is  possible  to  get  illustrations  which  shall  show  the  various 
methods  of  determining  the  amount  of  capitalization.  As  so  often 
before,  raikoad  operations  are  most  likely  to  serve  our  purpose,  for 
every  one  is  more  or  less  familiar  with  their  import. 

It  may  be  desirable  to  have  the  capital  accounts  represent  any 
one  of  three  points  of  view.  Sometimes  it  is  desired  that  a  business 
shall  be  capitalized  on  the  basis  of  its  earning  capacity,  sometimes 
on  the  basis  of  the  cost  of  duplication,  sometimes  on  the  basis  of 
original  cost.  The  main  capital  account  is,  of  course.  Construction, 
or,  as  it  is  commonly  called  in  a  railroad  report,  "Cost  of  Road." 
The  problem  for  our  purpose,  then,  is  to  determine  whether  certain 
costs  shall  be  charged  to  construction  or  to  maintenance.  If  they 
are  charged  to  construction,  they  appear  on  the  balance  sheet  as  a 
resource  at  the  end  of  the  year.  If  they  are  charged  to  maintenance, 
they  appear  on  the  income  sheet  among  the  expenses,  and  are  there- 
fore taken  out  of  revenue.  This  distinction  may  be  far-reaching; 
for  if  they  are  charged  to  construction,  the  expenditure  may  be  used 
as  an  argument  for  increasing  capital  stock  or  funded  debt.  The 
question  is  therefore  fundamental. 

Let  us  assume  that  the  railroad  has  a  bridge  carried  away  by  ice 
in  a  spring  freshet.  It  is  discovered  that  if  the  bridge  is  replaced  the 
same  sort  of  mishap  is  Hkely  to  occur  again.  Yet  the  road  can  find 
no  better  place  to  put  a  new  bridge  than  on  the  old  location.  To 
what  account  should  a  new  bridge  be  debited  ?  Clearly,  this  is  a  case 
for  a  maintenance  charge,  for  the  property  destroyed  is  replaced  by 
other  property  of  exactly  the  same  value  and  the  expense  of  replace- 
ment is  one  of  the  natural  costs  of  conducting  business.  The  only 


204  ACCOUNTS 

escape  from  such  a  charge  would  be  to  divide  the  cost  between  sev- 
eral years,  upon  the  assumption  that  the  expenditure  would  recur 
perhaps  once  in  four  or  five  years.  In  that  case  a  part  of  the  cost  might 
be  taken  out  of  surplus  and  the  rest  out  of  the  profit  for  the  year,  — 
that  is,  a  part  would  be  taken  out  of  accumulated  profits  shown  on 
the  balance  sheet  and  the  rest  would  be  included  in  costs  on  the 
income  sheet  for  the  year  just  past.  In  subsequent  years  provision 
should  be  made,  in  advance,  for  expected  loss  of  this  sort,  allowing, 
of  course,  for  accumulations  of  interest.  Unless  the  cost  is  extraor- 
dinary, however,  the  cost  should  not  be  divided  among  several 
years,  for  if  the  road  has  suffered  in  this  respect  the  chance  is  that  in 
some  other  particular  it  has  had  especially  good  luck  to  offset  this 
bad  luck.  As  was  indicated  in  the  earHer  discussion  of  depreciation, 
few  years  will  depart  far  from  the  average. 

Let  us  suppose  next  that  the  old  bridge,  which  was  of  wood,  is 
replaced  by  one  of  iron.  The  cost  will  be  very  much  greater.  The 
new  iron  bridge  will  better  withstand  the  pressure  of  the  ice  and  con- 
sequently require  replacement  less  often.  Shall  it  be  charged  to  con- 
struction or  to  maintenance  ?  In  this  case  application  may  well  be 
made  of  the  truth  shown  in  the  third  illustration  in  Chapter  VII. 
Since  it  is  expected  that  the  bridge  will  be  washed  away  in  perhaps 
ten  years,  its  expected  life  at  the  end  of  the  first  year  is  nine  years ; 
at  the  end  of  the  second  year,  eight ;  and  so  on  down.  It  is  possible, 
therefore,  to  charge  to  construction  the  cost  of  the  iron  bridge  in 
excess  of  that  of  the  replaced  wooden  bridge,  taking  out  of  revenue 
only  that  part  of  the  cost  which  is  equivalent  to  the  value  of  the 
old  bridge,  and  then  to  "write  off  "  —  that  is,  to  charge  to  revenue 
—  one  tenth  of  the  total  at  the  end  of  each  year,  so  that  the  cost  of 
the  bridge  as  a  whole  will  ultimately  be  taken  out  of  maintenance, 
each  year  suffering  its  share.  If,  on  the  other  hand,  it  should  be 
thought  that  the  iron  bridge  will  withstand  the  pressure  of  the  ice 
so  much  better  than  the  wooden  one  that  it  probably  will  not  be 
washed  away  at  all,  it  would  be  perfectly  proper  to  charge  the  excess 
to  construction  account.  The  principle  of  this  charge  is,  of  course, 
that  the  earnings  of  the  road  will  be  increased  by  the  fact  that  this 
heavy  item  of  maintenance  is  to  be  escaped  in  the  future,  that  the 
road  would  cost  more  for  duplication,  and  has  actually  cost  more  to 
the  builders.  From  all  three  points  of  view  mentioned  in  the  intro- 


GENERAL  PRINCIPLES   OF   CAPITALIZATION  205 

duction  to  this  chapter,  therefore,  this  charge  may  properly  be 
made  to  construction. 

Let  us  now  suppose  a  slight  change  in  conditions.  Let  us  suppose 
that  it  is  feared  that  the  bridge  would  be  at  best  in  a  position  too 
precarious  if  at  the  old  location,  and  hence  it  is  to  be  built  a  mile 
farther  up  the  river.  The  cost  of  the  bridge  alone  will  be  exactly 
as  in  the  case  last  discussed.  The  treatment  of  the  track,  however, 
raises  new  problems.  It  may  chance  that  to  connect  the  new  bridge 
with  the  old  track  by  one  mile  of  additional  track  on  each  side  of 
the  river  is  cheaper  than  to  move  several  miles  of  Hne.  We  have, 
then,  two  miles  of  absolutely  new  track,  that  is,  new  construction. 
Is  it  chargeable  to  construction  or  to  maintenance?  If  we  wish  our 
capitalization  to  represent  the  cost  of  the  road  to  the  builders,  this 
charge  clearly  should  go  to  construction.  If  we  wish  our  capitaliza- 
tion to  represent  earning  capacity,  it  should  be  to  maintenance,  for 
this  additional  two  miles  of  track  has  added  nothing  to  the  earning 
capacity  of  the  road,  —  indeed,  on  the  contrary,  it  has  probably 
increased  costs,  for  the  haul  is  longer  and  more  crooked  and  more 
line  must  be  kept  in  repair.  The  road  will  earn  more  in  the  end, 
but  not  more  than  it  was  expected  to  earn  before;  and  since  the 
previous  capitalization  was  based  on  expected  earnings,  no  change 
in  capitalization  is  necessary.  If,  finally,  we  wish  our  capitalization 
to  represent  cost  of  duplication,  this  additional  mile  may  be  charged 
to  construction.  We  are  confronted  with  a  dilemma,  therefore. 

We  may  get  new  light  if  we  make  our  assumption  more  specific. 
Let  us  suppose  the  road  would  have  been  built  straight  to  the  new 
location  for  the  bridge  had  it  been  known  originally  that  freshets 
were  likely  to  occur  at  the  old  location.  Under  these  conditions, 
presumably,  this  two  miles  of  riverside  track  is  not  properly  one  of 
the  elements  of  duplication;  the  building  of  this  extra  track  has 
been  due  to  a  mistake  in  the  engineer's  laying  of  the  road.  Du- 
plication would  avoid  it.  It  is  not,  therefore,  a  legitimate  charge  to 
capital  as  registering  cost  of  duplication.  If,  on  the  other  hand, 
capitalization  is  to  represent  cost  to  the  builders,  and  the  original 
builders  of  the  road  employed  the  best  engineer  that  they  could  se- 
cure for  a  reasonable  compensation,  they  were  not  to  blame  for  the 
error;  and,  therefore,  the  extra  cost,  as  an  element  in  the  sacrifice 
they  have  made  in  constructing  the  road,  may  be  charged  to  con- 


206  ACCOUNTS 

struction  account.  Again,  therefore,  a  slight  difference  in  the  point 
of  view  changes  our  disposition  of  the  charge. 

If,  to  alter  our  supposition  once  more,  it  chances  that  at  either  end 
of  the  new  bridge  is  a  range  of  hills  such  that  the  Hne  could  not 
have  been  built  direct  to  the  bridge,  but  could  reach  it  only  by  means 
of  this  extra  two  miles  of  track,  this  charge  for  the  extra  miles  can 
be  made  to  construction  whether  we  wish  capitalization  to  represent 
the  cost  of  duplication  of  the  road  or  the  cost  to  the  builders  of  it ; 
for  under  this  supposition  the  road  as  it  now  stands  is  on  the  only 
available  route.  It  still  remains  true,  however,  that  in  the  view  of 
construction  as  capitalized  earning  power  these  extra  miles  must  be 
charged  to  maintenance,  for  they  have  not  increased  expected  earn- 
ings or  reduced  expected  costs. 

Let  us  suppose,  finally,  that  the  management  concludes  that  rather 
than  build  this  extra  two  miles  of  track  with  sharp  curves  leading 
from  the  old  bridge  site  to  the  new,  it  will  tear  up  two  miles  of  track 
on  each  side  of  the  river  and  relay  them  direct  to  the  new  bridge. 
Shall  this  charge  for  tearing  up  old  tracks  and  laying  new  ones  be 
made  to  construction  or  to  maintenance  ?  In  the  view  of  capitaliza- 
tion as  representing  earning  capacity,  the  charge  clearly  should  be 
made  to  maintenance.  In  the  view  of  capitalization  as  registering 
the  sacrifice  made  by  the  builders,  the  charge  should  be  made  to 
construction,  —  for  the  error  was  innocent.  In  the  view  of  capital- 
ization as  probable  cost  of  dupHcation,  the  charge  should  be  made 
to  maintenance ;  for  the  old  location  would  not  now  be  used  and  the 
new  is  merely  a  substitute  for  it. 

Here,  then,  we  are  face  to  face  with  a  complete  contradiction  in 
method,  arising  from  the  difference  in  point  of  view.  When  we  come 
to  consider  the  history  of  railroad  accounting  in  this  country,  we 
find  methods  quite  as  contradictory.  Even  though  standard  roads 
be  chosen  for  study,  it  will  be  found  that  items  which  one  road 
charges  to  maintenance  can  be  almost  exactly  duplicated  by  similar 
items  charged  on  another  to  construction. 

There  is,  of  course,  a  principle  that  can  determine  which  account 
should  be  charged  in  any  particular  case.  Let  us  see  what  advan- 
tages follow  from  each  of  the  three  possible  points  of  view  with  re- 
gard to  capitalization.  Then  we  may  choose  between  them  and  have 
a  working  basis  for  all  cases. 


GENERAL  PRINCIPLES  OF  CAPITALIZATION  207 

Recently  a  proposition  has  been  prominently  made  public  for 
abolishing  all  capitaHzation  as  expressed  in  terms  of  money.  This 
owes  its  origin  to  a  recognition  of  several  principles  to  be  set  forth 
below,  but  it  neglects  a  point  most  important  for  the  accountant,  — 
namely,  that  some  sort  of  capitalization  is  necessary  for  any  scien- 
tific bookkeeping.  We  shall  soon  see,  moreover,  that  what  will  serve 
the  purpose  is  not  an  abolition  of  capitalization,  but  an  acceptance 
of  the  only  basis  that  can  have  any  real  meaning. 

First,  what  purpose  is  served  by  seeking  to  show  upon  books  of 
account  the  probable  cost  of  dupHcating  a  commercial  or  industrial 
or  transportation  agency  ?  If  the  property  of  a  business  is  to  be  sold 
as  property,  independent  of  the  organization  that  makes  of  it  an 
economic  unit,  such  cost  is  a  desirable  figure  for  the  buyer  (and 
therefore  for  the  seller)  to  know.  The  discussion  of  municipal  owner- 
ship of  public-service  utilities  would  more  often  have  point  if  the  cost 
of  duplicating  the  private  equipment  were  exactly  known.  Here, 
however,  the  advantage  of  this  sort  of  knowledge  seems  to  end. 
Many  demands  have  been  made  of  late  years  that  the  dividends  of 
corporations  be  Hmited  by  law  to  the  equivalent  of  a  "reasonable" 
percentage  on  the  cost  of  duplication.  If  such  a  demand  were  to  be 
enforced,  accounting  to  record  such  cost  would  be  an  advantage. 
We  must  see,  however,  that  no  accounting  could  record  such  cost  of 
duplication  except  by  constant  changes  in  the  valuation  of  assets, 
and  such  changes  could  be  recorded  only  by  a  constant  comparison 
of  lastValuations  with  market  prices.  In  other  w^ords,  the  accounting 
would  be  devoted  very  largely  to  matters  having  no  relation  to  the 
business  as  a  going  concern.  It  is  obvious,  too,  that  all  this  detailed 
accounting  could  serve  no  real  purpose.  Why  make  new  valuations 
on  the  books  every  few  months  in  order  to  determine  the  legal  rate 
of  dividend,  when  the  restriction  of  dividend,  a  purely  legal  matter 
having  no  relation  to  the  business  as  a  going  concern,  may  as  well 
be  determined  from  figures  outside  the  books  ?  The  thing  that  is  of 
importance  for  the  business  is  what  its  equipment  actually  cost, 
not  what  such  equipment  would  have  cost  under  other  conditions. 
If  actual  costs  are  recorded,  with  the  date  of  occurrence,  the  cost 
of  duplication  can  always  be  figured  by  a  comparison  of  prices  paid 
with  current  prices ;  so  the  argument  for  keeping  cost  of  duplication 
on  the  books  entirely  disappears.    Of  the  justice  of  limiting  divi- 


208  ACCOUNTS 

dends  to  a  ''reasonable"  percentage  not  of  the  actual  sacrifices  made 
but  of  something  that  never  happened,  nothing  need  be  said  in  a 
book  of  this  sort.  It  is  necessary  to  note  only,  as  an  important  ac- 
counting principle,  that  accounts  are  not  worthy  of  the  name  if  they 
allow  known  facts  to  be  hidden  and  the  record  ultimately  destroyed 
under  guesswork  of  what  might  have  been. 

Second,  what  is  the  advantage  of  capitalizing  on  the  basis  of  earn- 
ing capacity  ?  The  income  sheet,  if  properly  constructed,  shows  all 
net  earnings.  All  earnings  made  should  appear  here,  or  else  the 
sheet  contains  a  lie.  Of  what  advantage  is  it  to  capitalize  the  figure 
of  net  earnings  shown  on  the  income  sheet  and  write  up  or  write 
down  the  capital  accounts  on  the  balance  sheet  ?  The  mere  school- 
boy, if  you  tell  him  the  earnings  of  a  company  and  the  rate  of  inter- 
est, can  tell  you  its  capitalized  value.  In  other  words,  to  register  on 
the  books  a  capitalization  based  on  earning  capacity  is  not  only  to 
register  an  unnecessary  figure  but  to  bury  the  actual  cost  of  the 
assets. 

Finally,  to  capitalize  on  the  basis  of  cost,  or,  to  express  it  more 
exactly,  to  let  capitaHzation  take  care  of  itself  under  simple  straight- 
forward methods,  is  to  preserve  a  figure  which  every  one  wishes  to 
see  preserved.  The  builders  desire  to  know  their  sacrifice,  the  in- 
vestors desire  to  know  just  what  has  become  of  their  money,  the 
buyers  desire  to  know  what  has  been  spent,  the  public  thinks  it  has 
a  right  to  know  whether  the  dividends  bear  a  proper  relation  to  the 
actual  investment.  It  is  obvious,  too,  that  if  this  figure  be  once 
lost,  it  can  hardly  be  recovered.  Both  cost  of  duplication  and 
capitalization  on  earning  capacity  may  be  readily  determined  in- 
dependently of  balance-sheet  figures;  but  if  construction  be  con- 
fused on  the  books  with  maintenance,  the  actual  cost  is  buried 
forever. 

It  is  time  to  see  just  what  we  mean  by  cost.  We  might  as  well  ob- 
serve at  the  start  that  the  only  defensible  aim  of  accounting  is  to  tell 
the  truth;  but  accountants  can  no  more  convey  the  truth  when  they 
use  words  carelessly  than  can  other  people:  neither,  on  the  other 
hand,  can  they  be  expected  to  convey  the  truth  more  exactly  than 
other  people  if  their  words  are  misinterpreted  or  perverted  by  those 
who  read  their  reports  or  if  the  information  on  which  they  base  their 
reports  is  couched  iiji  words  with  perverted  meaning.  To  refuse  to 
use  a  proper  term,  such  as  cost,  for  fear  that  some  one  will  misin- 


GENERAL   PRINCIPLES   OF    CAPITALIZATION         209 

terpret  it,  and  pretend  that  it  means  valuation,  is  to  make  truth- 
telling  impossible.  When  we  say  that  the  proper  basis  for  capital- 
ization is  cost,  we  do  not  mean  to  include  in  cost  waste  of  resources, 
or  gratuities  by  the  way,  or  any  other  expenditure  that  was  not 
reasonably  made  for  the  purpose  of  serving  the  end  recorded  on  the 
books.  The  word  ''sacrifice"  carries  the  proper  connotation.  The 
books  should  show  what  sacrifice  of  capital  was  made  in  securing 
the  assets  that  the  business  uses.  Resources  wasted,  either  through 
carelessness  and  indifference  or  through  misapplication  of  fimds, 
are  not  costs,  and  cannot  be  capitalized  under  any  proper  account- 
ing; but  resources  that  were  applied  with  proper  intent,  and  after 
reasonable  consideration  by  proper  judges,  are  costs,  or  sacrifice, 
even  though  the  judgment  was  faulty  and  the  issue  is  not  fortunate. 
In  other  words,  the  books  should  show  what  was  spent  for  the  pur- 
pose indicated  by  the  title  of  the  account;  and  no  sums  spent  for 
other  purposes,  even  though  they  may  have  been  tied  up  with  the 
original  purpose,  should  be  included.  Sums  spent  in  buying  office 
furniture  at  high  prices  to  curry  favor  with  furniture  dealers 
are  not  properly  chargeable  to  Office  Furniture  —  except  to  the 
amount  of  the  reasonable  value  of  that  furniture. 

One  purpose  of  accounting  is  indeed  to  show  valuations ;  but  a 
far  more  important  purpose  is  to  show  costs.  As  has  been  indi- 
cated, it  is  possible  to  make  even  a  single  balance  sheet  show  both. 
If  the  principal  account  preserves  costs,  a  contra  account  —  an 
allowance  account  —  may  show  any  deduction  to  be  made  for 
shrinkages  in  value  due  to  errors  in  judgment,  to  changes  in  market 
conditions,  or  to  depreciation.  Preferably  depreciation  should  not 
be  included  in  such  allowances,  for  it  is  not  a  capital  cost  but  an 
operating  cost;  such  costs  should  be  written  off  valuations,  for  they 
do  not  represent  capital  sacrifice.  All  capital  costs,  on  the  other 
hand,  are  worth  preserving,  and  often  are  worth  showing.  When 
coupled  with  allowances,  properly  labeled  on  the  credit  side  of  bal- 
ance sheets  or  deducted  in  short-extension  on  the  asset  side,  they 
should  not  mislead.  Let  us  take  an  illustration.  Suppose  a  property 
cost  $200,000,  acquired  in  the  most  straightforward  and  economi- 
cal way;  it  is  operated  for  one  year  in  such  a  way  that  maintenance 
is  impossible,  and  depreciation  occurs  amounting  to  $25,000;  the 
conduct  of  business  results  in  a  dividend  of  only  3%,  and  the  stock- 


2IO  ACCOUNTS 

holders  believe  therefore  that  they  have  by  their  enterprise  sacri- 
ficed 3%,  for  they  think  they  could  have  earned  6%  with  their 
money  elsewhere;  finally,  a  change  in  industry  suggests  that  this  is 
a  dying  enterprise  —  a  mistaken  enterprise  —  and  the  property 
is  worth  for  sale  purposes  only  $100,000.  Some  advocates  of  the 
cost  theory  of  capitalization  may  say  that  the  cost  or  sacrifice 
of  the  owners  is  $206,000  —  $200,000  of  original  investment  and 
$6000  in  lost  profits,  —  which  they  would  put  on  the  balance  sheet 
as  the  cost  of  the  property.  Others  will  say  that  the  balance  sheet 
should  value  the  property  at  $200,000,  the  original  cost,  and  show 
depreciation  as  a  liability  of  $25,000.  Advocates  of  the  valuation 
theory  of  capitalization  would  give  the  property  on  the  balance 
sheet  a  figure  of  $100,000  —  the  estimated  selling  price.  The  clear 
statement  is  really  this: 

Property  at  cost  less  Allowance  for  shrinkage  in 

depreciation  $175,000        value  of  property  $75,000 

Here  we  have  no  mixture  of  unlike  things.  The  cost  of  the  property 
rema.ining,  unconsumed  in  the  operations  of  the  enterprise,  is  cor- 
rectly given  as  $175,000;  and  whether  the  enterprise  paid  adequate 
piofits  or  not  is  a  question  which  the  balance  sheet  was  not  meant 
to  answer,  for  the  income  sheets  are  adequate  for  that  purpose  and 
for  showing  what  depreciation  entered  into  operating  costs;  and 
the  present  value  of  the  property  is  indicated  by  the  correlation, 
sufiiciently  suggested  by  the  balance  sheet,  of  the  Allowance  and 
the  Property  account.  Under  this  plan,  all  desirable  information 
is  not  only  preserved  but  shown;  the  form  of  statement  avoids  not 
only  confusion  of  operating  or  revenue  facts  with  capital  facts,  but 
also  confusion  of  costs  with  valuations. 

To  summarize,  no  theoretical  accounting  aims  support  any  view 
of  capitaKzation  other  than  cost.  Why  is  it  that  in  practice  capi- 
taKzation  is  often  a  purely  arbitrary  figure  of  no  import?  In  most 
cases  one  of  two  explanations  will  hold.  Either  the  managers  wish  to 
hide  excessive  dividends,  or  they  fear  that  dividends  which  they  deem 
only  fair,  or  even  inadequate,  will  to  the  public  appear  excessive. 
In  other  words,  public  opinion,  too  weak  to  enforce  justice,  is  just 
strong  enough  to  frighten  a  little  both  the  guilty  and  the  innocent. 
Public  opinion  has  been  singularly  obtuse  in  its  consideration  of  the 
f imctions  of  capital.    At  some  times  and  places  it  has  neglected  to 


GENERAL    PRINCIPLES   OF   CAPITALIZATION  2X1 

see  that  some  investors  were  getting  more  than  they  deserved,  and  at 
other  times  and  places  it  has  been  unwilling  that  others  should  get 
anywhere  nearly  so  much  as  they  deserved.  Men  who  will  not  risk 
a  cent  in  any  venture  which  the  needs  of  public  service  seem  to  re- 
quire will  complain  in  bitter  terms  of  the  extortion  of  investors  when 
such  a  venture  brings  large  profits ;  and  they  will  sneer  at  the  same 
investors  when  some  other  enterprise  fails  and  the  extraordinary 
gains  of  the  first  have  been  lost.  Clearly  if  the  justice  of  profits  is  to 
be  determined  by  actual  costs,  so  that  all  profits  higher  than  what 
the  public  calls  "reasonable'^  are  to  be  confiscated,  society  must 
provide,  in  order  to  even  things,  that  on  all  ventures,  whether  so- 
cially necessary  or  merely  whimsical,  reasonable  profits  shall  be 
guaranteed.  Does  any  one  think  that  society  can  afford  to  give  such 
a  guarantee?  If  society  leaves  the  adventurer  to  "take  his  medi- 
cine" after  failure,  it  must  leave  him  more  or  less  free  to  reap  his 
harvest  after  success.  The  temper  of  many  critics  of  overcapitaliza- 
tion is  that  of  "Heads  I  win,  tails  you  lose."  That  there  is  vast 
overcapitalization  in  some  corporations,  and  that  overcapitalization 
is  widespread,  no  one  thinks  of  denying.^  That  it  is  due  in  large  part 
to  heedless  or  ignorant  criticism  of  seemingly  high  dividends  is  cer- 
tain. That  it  is  harmful  to  any  one  except  deceived  investors  cannot 
be  shown.  Remembering  that  we  are  concerned  here  only  with  the 
facts  as  they  can  be  recorded  in  books  of  account,  let  us  examine 
the  meaning  of  this  overcapitaHzation. 

This  word  "capitahzation"  is  used  with  a  wide  scope  of  meaning. 
Commonly  it  means  the  figure  of  permanent  liabiUties  of  a  corpora- 
tion, liabilities  that  are  not  intended  for  early  redemption, —  prac- 
tically nothing  but  capital  stock  and  funded  debt,  though  sometimes 
including  surplus.  A  holder  of  funded  debt  does  not  normally  de- 
sire that  the  bond  shall  be  paid ;  he  has  bought  it  to  yield  an  income, 
with  the  expectation  that  with  his  money  the  road  will  earn  some- 
thing for  him.    So  capital  stock  and  funded  debt  are  the  capital 

^  Recent  studies  of  railroad  valuations  give  good  evidence  that  the  overcapitaliza- 
tion often  complained  of  is  not  to  be  found  there.  Many  roads  have  charged  to 
maintenance  millions  of  dollars  that  might  have  been  properly  charged  to  construc- 
tion and  used  as  a  basis  for  new  stock  or  bonds.  The  real  estate  of  many  roads,  more- 
over, especially  at  large  terminals,  has  appreciated  in  value  enormously  in  recent 
years,  but  of  that  fact  the  accounts  have  usually  taken  no  cognizance.  The  striking 
cases  of  overcapitalization  have  been  chiefly  in  industrial  enterprises. 


212  ACCOUNTS 

liabilities,  and  comprise  in  one  sense  its  capitalization.  The  cor- 
poration's permanent  assets,  on  the  other  hand,  —  such  as,  in  a  rail- 
road, its  roadway  and  real  estate,  its  rolling  stock,  and  its  stocks 
and  bonds  in  other  companies, —  are  sometimes  called  its  capitaliza- 
tion. As  a  matter  of  fact,  capital  assets  and  capital  liabilities,  as  will 
be  illustrated  in  the  chapter  on  railroad  accounts,  are  normally  about 
equal.  So  it  matters  Uttle  which  use  of  the  word  "capitalization" 
we  adopt.  Our  question,  then,  is  this.  What  facts  do  practical  in- 
terests require  corporation  books  to  show  regarding  capital  assets 
and  capital  habilities? 

We  have  already  seen  that  to  try  to  record  cost  of  duplication  as 
a  basis  for  capitalization  is  not  only  laborious  but  largely  unneces- 
sary. We  have  remaining  as  practicable  bases,  then,  only  earning 
capacity,  and  sacrifice,  or  cost.  The  former  we  have  shown  to  be 
largely  adopted  by  corporations,  much  condemned  by  the  pubHc, 
and  from  the  accounting  point  of  view  hardly  scientific.  Let  us  see 
the  ultimate  result  of  adopting  each  of  these  bases  in  a  simple  case. 
We  saw  in  an  earlier  paragraph  that  the  charge  for  new  track  to 
connect  with  a  new  bridge,  necessitated  by  freshets,  may  be  made 
to  construction  on  the  ground  that  the  stockholders  of  the  road  are 
entitled  to  income  on  this  cost  incurred  by  them,  or  it  may  be  made 
to  maintenance  on  the  ground  that  it  does  not  increase  earnings. 
The  point  of  view  makes  the  difference.  The  former  of  these  plans 
increases  capitalization,  the  other  maintains  it.  What  is  the  effect 
on  dividends? 

Charging  to  maintenance  includes  the  expenditure  among  costs, 
reduces  net  earnings,  and,  consequently,  reduces  dividends.  Char- 
ging to  construction  assumes  that  the  expenditure  is  a  full  asset, 
and  consequently  leaves  earnings  unaffected.  Increasing  capitaliza- 
tion, then,  appears  to  give  better  results  to  the  stockholders.  Let 
us  carry  the  matter  through  to  the  end,  however.  In  either  case  the 
money  has  been  spent,  is  gone,  is  not  now  available  for  paying  divi- 
dends. However  great  or  small  earnings  may  be,  this  expenditure 
for  track-laying  has  reduced  available  assets  below  what  they  would 
have  been  if  the  expenditure  had  not  been  made.  One  cannot  eat 
one's  cake  and  have  it  too.  Even  though  the  charge  be  made  to 
capital,  but  three  possible  ways  can  be  found  for  distributing  as 
much  in  dividends  as  could  have  been  distributed  if  this  new  track  had 


GENERAL   PRINCIPLES  OF  CAPITALIZATION  213 

not  been  laid,  —  issuing  and  selling  new  stock,  distributing  a  scrip 
dividend,  and  borrowing.  Unless  some  fund  within  the  business  is 
encroached  upon,  outside  funds  must  be  used.  These  three  methods 
increase  capital  liabilities  to  correspond  with  the  increase  in  capital 
assets.  The  first  two  of  these  increase  the  amount  of  stock  outstand- 
ing, and  hence  increase  the  number  of  shares  among  which  the  divi- 
dend is  to  be  distributed.  In  order  to  maintain  the  old  amount  of 
dividend,  an  increase  has  been  made  in  the  number  of  shares,  so  that 
each  share  shall  receive  now  less  than  before  —  just  as  much  less 
than  before  as  it  would  have  received  if  the  new  track  had  been 
charged  directly  to  maintenance  and  had  been  taken  out  of  profits. 
If,  on  the  other  hand,  money  was  borrowed  to  make  up  in  dividend 
for  the  money  put  into  new  track,  the  interest  charges  are  increased, 
net  earnings  are  reduced,  and  the  future  loses  what  this  year  tried  to 
avoid  losing.  In  other  words,  calling  a  thing  construction  rather 
than  maintenance,  though  it  shows  greater  profits  on  the  books,  does 
not  furnish  the  means  to  pay  greater  dividends.  The  result,  in  actual 
tangible  things,  is  quite  the  same  as  if  maintenance  had  been  charged. 
The  public,  then,  so  far  as  it  considers  itself  concerned  in  dividends, 
has  no  interest  in  the  question  whether  the  charge  is  made  to  main- 
tenance or  to  construction,  that  is,  whether  capital  is  increased  or 
not.  So  far,  on  the  other  hand,  as  the  public  is  concerned  to  know 
whether  the  builders  of  the  road  are  receiving  just  returns  on  their 
investment,  it  should  wish  the  charge  to  be  made  to  construction; 
for  if,  as  in  the  case  assumed  (detailed  on  page  205),  the  builders 
committed  an  innocent  engineering  error,  the  books  should  show 
that  their  capital  is  actually  increased  and  that  they  have  not  yet 
got  increased  compensation  for  increased  sacrifice.  Cost,  that  is 
to  say,  should  be  the  basis  of  capitalization.  Speculators  and  in- 
vestors, of  course,  may  prefer  that  maintenance  shall  be  charged, 
in  order  that  it  may  show  them  that  the  directors  expect  the  road  to 
earn  no  more  because  of  this  new  track ;  but  such  information  may 
be  given  without  hiding  the  valuable  figure  of  actual  costs. 

The  only  other  method  of  excessive  capitalization  is  deliber- 
ately writing  up  the  assets  and  issuing  stock  or  bonds  to  correspond. 
As  has  been  elsewhere  stated,  this  is  usually  done  at  a  time  of  com- 
bination or  of  reorganization.  This  process,  obviously,  can  have  no 
effect  on  earnings  —  and  consequently  can  have  none  on  the  amount 


214  ACCOUNTS 

of  dividends.  It  results  in  a  smaller  percentage  of  dividend  on  a 
larger  capitalization.  The  public  is  not  concerned.  Speculators  and 
investors,  on  the  other  hand,  are  often  misled,  and  have  a  right  to 
object  to  this  method. 

The  public  objection  to  overcapitalization,  then,  has  no  warrant  in 
the  notion  that  dividends  are  affected.  The  real  warrant  lies  solely 
in  the  fact  that  the  relation  between  cost  and  dividends  is  hidden. 
Yet,  as  a  matter  of  fact,  overcapitalization  as  commonly  practiced 
need  not  hide  the  relation  of  cost  to  dividends  worse  than  other  plans 
that  have  been  proposed  to  remedy  the  evil.  One  does  not  judge 
the  rightfulness  of  a  man's  income  until  one  knows  his  history,  his 
occupation,  his  ability,  his  fortune.  No  more  should  one  judge  the 
rightfulness  of  the  dividends  of  a  corporation  until  one  knows  its 
history,  its  assets,  its  liabilities.  It  is  mere  triviality  to  say  that  ten, 
twenty,  or  even  thirty  per  cent,  dividend  is  necessarily  the  result  of 
extortion.  Five  per  cent,  dividend  on  one  million  dollars  of  stock 
may  be  precisely  the  same  thing  as  twenty-five  per  cent,  dividend 
on  two  hundred  thousand  dollars  of  stock,  and  it  makes  not  the 
slightest  difference  to  anybody  which  capitalization,  with  its  corre- 
sponding dividend,  is  used.  Stock  cannot  be  watered  without  the 
water  affecting  the  rate  of  dividend,  and  if  critics  would  cease  to 
worry  about  capitalization  and  watch  actual  cash  dividends  instead, 
they  would  have  information  that  would  mean  something. 

This  last  proposition  is  deserving  of  enlargement.  If  we  wish  to 
know  the  justice  of  the  dividends  of  a  corporation,  what  do  we  need 
to  know  ?  Three  things :  what  the  investors  have  put  in ;  what  risks 
they  have  taken ;  what  they  have  taken  out.  Nothing  else  can  be  of 
any  importance  in  settling  our  question.  The  first  of  these  can  be 
readily  learned  if  the  books  are  properly  kept,  and  published  reports 
should  show  it,  —  not  necessarily  repeated  every  year,  though  that 
is  desirable,  but  reported  whenever  a  change  occurs.  Then  the  his- 
tory of  the  corporation  can  be  known.  In  the  argument  of  a  few 
pages  back,  insistence  was  laid  on  the  accounting  value  of  having 
separate  costs  carefully  recorded.  For  the  purpose  of  our  argument 
here,  however,  that  is  not  necessary.  All  that  concerns  the  critic  of 
dividends  is,  in  this  particular,  total  investment  by  stockholders. 
The  cost-of-road  account  may  be  written  up  and  the  stock  may  be 
watered  to  any  degree,  without  misleading  any  one  if  the  actual  in- 


GENERAL  PRINCIPLES  OF   CAPITALIZATION         21 5 

vestment  of  i;he  stockholders  be  known.  Next,  obviously,  no  one  can 
fairly  judge  of  any  rate  unless  he  understands  the  risk  involved. 
Finally,  we  must  know  what  has  been  taken  out  by  stockholders, 
not  in  terms  of  percentage  of  nominal  capital  stock,  but  in  absolute 
amount,  so  that  we  may  compare  it  with  actual  investment.  Do  we 
need  to  know  the  stock  dividends?  As  has  been  already  suggested, 
stock  dividends  do  not  provide  funds.  Of  what  avail  is  any  stock 
if  no  dividends  are  paid  on  it?  Until  cash  dividends  are  paid  on 
watered  stock,  the  water  is  of  no  value  to  any  one  except  for  specu- 
lative purposes;  and  when  that  dividend  is  paid,  the  total  amount 
of  cash  dividends  must  go  up.  Then  something  has  been  taken  out  by 
stockholders,  and  the  figure  is  worth  watching.  So,  in  the  last  analy- 
sis, the  only  concern  of  the  public  is  the  relation  between  investment 
and  cash  dividends  taken  out.  Percentages  of  capital  stock  have 
no  meaning. 

This  is  worth  an  illustration.  Suppose  a  corporation  is  organized 
with  capital  stock  nominally  of  $1,000,000,  with  $200,000  paid  in,  — 
the  rest  being  offset  by  exaggeration  of  assets.  If  the  corporation 
earns  $50,000,  and  pays  5%,  the  dividend  is  25%  on  the  actual  in- 
vestment. If  in  the  next  year  the  earnings  are  $100,000,  and  $50,000 
for  dividends  is  paid  in  cash,  the  rest  of  the  earnings,  $50,000,  may 
be  issued  as  stock  dividend.  Next  year  the  earnings  may  be  $1 50,000, 
with  $50,000  paid  in  cash  (a  lower  rate  on  the  outstanding  stock  but 
still  25%  on  actual  investment)  and  $100,000  added  in  stock  divi- 
dend. The  capital  stock  will  stand  now  at  $1,150,000;  of  which 
$800,000  is  water,  $200,000  is  original  investment,  and  $150,000  is 
profits  remaining  in  the  business.  So  long  as  only  $50,000  is  paid  in 
cash  dividend,- the  stockholders  are  getting  out  of  the  business  only 
25%  upon  their  investment.  Let  us  suppose  that  now  more  capital 
is  actually  invested  by  the  stockholders,  say  another  $200,000  paid 
for  $1,000,000  in  stock.  The  capital  stock  is  now  $2,150,000; 
$400,000  invested,  $i,6co,ooo  water,  $150,000  profits.  If  earnings 
now  become  $322,500,  15%  on  the  nominal  capital,  and  are  dis- 
tributed in  full,  the  situation  may  be  summarized  briefly  as  follows : 
in  addition  to  the  nominal  rate  on  the  actual  investment,  5%  divi- 
dend was  paid  for  three  years  on  $800,000  water,  and  the  last  year 
15%  was  paid  on  $1,600,000  water  and  on  $150,000  profit  accumu- 
lated above  the  amount  distributed  in  the  first  two  years.   We  can 


2l6  ACCOUNTS 

thus  figure  the  excess  above  the  nominal  rate,  giving  an  actual  rate 
of  38.9%.  Yet  the  person  who  knows  nothing  of  the  water  or  of  the 
stock  dividend  can  get  practically  as  much  information  as  we  pro- 
vided he  is  able  to  get  figures  showing  the  actual  investment  and 
the  actual  cash  dividends;  for  these  (dividing  the  latter  by  the 
former)  give  an  average  rate  of  38.9%  a  year/ the  same  figure  we  got 
by  the  detailed  method.  So  water  and  reinvestments  do  not  really 
interest  him;  for  they  affect  the  total  dividends  if  they  avail  any- 
thing, and  they  are  unobjectionable  if  they  avail  nothing.  Our  sole 
concern  is  to  know  whether  38.9%  is  too  much  in  this  particular 
case.  Suppose  it  be  assumed  that  20%  on  the  actual  investment  is 
enough  for  a  business  of  this  sort.  (Of  course  the  argument  for  lim- 
iting corporation  profits  is  based  almost  wholly  on  the  legal  fact  that 
corporations  are  given  by  society  special  privileges  which  distinguish 
them  from  partnerships,  and  hence  society  has  a  right  to  control 
them.)  We  know,  then,  that  the  dividend  is  excessive  by  an  average 
of  18.9%;^  and  we  have  got  this  figure  with  no  other  information 

*  The  method  of  figuring  here  is  shown  in  the  two  tables  below.  The  first  table 
uses  capitalization  and  then  adjusts  the  rate  of  dividend  by  an  allowance  for  the 
amount  of  water  in  the  stock.  The  second  regards  only  cash  dividends  and  actual 
investment. 

I 

Propor-  Actual 

tion  of       nT.,u:^i:^,     percent- 
Per-  actual       ^^^'^'       age  of 

Year     Capitalization        Dividend        centage         invest-        vprtma      dividend 

ment  in        verimg      ^^  invest- 
the  stock  ment 

1  $1,000,000  $  50,000  5  ^  5  25 

2  1,000,000  50,000  5  i  5  25 

3  1,050,000  50,000  4.76  ^  5^  24.99 

4  2,150,000  322,500  15  :f%  5f  80.62 

4|i55-6i 
Average  38.9 

II 
Year  Actual  investment  Cash  dividends  Percentage 

1  $200,000  $  50,000  25 

2  200,000  50,000  25 

3  200,000  50,000  25 

4  400,000  322,500  80.6 

4|i55-6 
Average  38.9 

'  If  objection  is  made  on  the  ground  that  stockholders  are  entitled  to  dividends  oa 
profits  left  in  the  business,  the  answer  is  that  such  dividends  are  justified  only  on 
profits  not  excessive.  The  actual  cash  dividend,  which  includes  earnings  on  profits 


GENERAL  PRINCIPLES  OF  CAPITALIZATION  21 7 

than  the  actual  investment  and  the  cash  dividends.  We  have 
needed  to  know  nothing  about  overcapitalization,  or  water,  or 
profits,  or  stock  dividends. 

We  have  seen,  then,  that  the  popular  criticisms  of  overcapitali- 
zation are  to  great  extent  based  on  misconceptions;  for  overcapital- 
ization has  no  part  in  increasing  earnings,  and  it  can  hide  the  justice 
of  dividends  only  when  original  investment  is  falsely  stated.  Over- 
capitalization does  deceive  in  practice,  however,  because  few  read  re- 
ports intelligently;  and  no  doubt  it  will  be  employed  until  the  pub- 
lic comes  to  have  a  more  enlightened  view  of  the  compensation  due 
for  risks  in  various  kinds  of  enterprise.  It  is  true,  nevertheless,  that 
in  every  point  of  view  except  that  of  the  man  who  thinks  he  must 
misrepresent  costs  in  order  to  secure  merely  fair  compensation 
for  risks,  capitaHzation  at  actual  cost  is  the  desideratum;  for,  as  it 
has  been  the  purpose  of  this  chapter  to  show,  the  figure  of  cost  is 
most  serviceable  for  the  manager,  for  the  economist,  for  the  investor, 
and  for  the  determination  of  justice  in  prices  and  rates. 

A  corollary  of  these  principles  is  sometimes  strikingly  neglected. 
While  public  opinion  is  complaining  of  overcapitalization,  a  con- 
siderable body  of  it  is  also  complaining  of  undercapitalization  — 
not  reaHzing  the  contradictory  attitude.  It  is  commonly  said,  for 
instance,  that  many  railroads  are  charging  to  maintenance  what  they 
should  charge  to  construction, —  thus  understating  profits  and 
accumulating  what  are  sometimes  called  "secret  reserves."  Obvi- 
ously what  is  said  is  true.  To  charge  to  maintenance  new  construc- 
tion and  other  improvements  that  will  increase  earnings  is  to  reduce 
apparent  profits  and  to  hide  valuable  assets.  If  these  assets  were 
properly  recorded,  the  figure  of  surplus,  or  reserve,  would  be  in- 
creased; and  hence  the  reserve  is  actual,  but  secret.  The  reason 
given  for  this  practice  is  that  such  roads  prefer  to  maintain  large 
margins  of  safety  for  poor  years,  rather  than  to  distribute  extra 
earnings  to  stockholders.  It  is  recognized,  then,  that  by  the  amount 
of  these  secret  reserves  earnings  are  larger  than  they  are  reported. 
Is  the  public  concerned  ?  So  long  as  these  resources  are  kept  in  the 
railroad  —  that  is,  are  spent  in  improving  the  Hne  and  the  equip- 

reinvested,  is  the  only  measure  of  benefit  to  stockholders;  and  if  20%  was  enough, 
the  extra  18.9%,  in  part  paid  on  profits  reinvested,  was  earned  by  profits  originally 
excessive  and  consequently  never  properly  belonging  to  the  stockholders  to  reinvest. 


21 8  ACCOUNTS 

ment,  —  who  gets  the  benefit  ?  Surely  not  the  stockholders,  until 
cash  dividends  are  distributed  from  these  new  earnings.  The  pub- 
lic, on  the  other  hand,  is  getting  better  and  better  service  from  the 
disposition  of  these  secret  reserves,  and  it  can  hardly  complain 
with  good  cause.  Even  if  earnings,  including  the  hidden  part,  are 
too  high,  there  should  be  no  complaint  if  the  excess  goes  back  into 
the  road.  Only  when  the  stockholders  plan  to  take  out  of  the  road, 
in  increased  cash  dividends,  these  earnings  that  some  people  think 
excessive,  can  the  public  even  pretend  that  it  is  exploited.  Usually, 
of  course,  the  complaint  is  accompanied  by  a  demand  for  lower  rates. 
The  question  is  simply  whether  the  people  prefer  better  railroads 
or  lower  rates.  If  the  power  of  distribution  of  dividend  is  practically 
without  check,  the  public  is  naturally  eager  to  see  that  these  improve- 
ments, made  from  earnings  paid  by  the  pubHc,  be  not  allowed  to 
swell  dividends  thought  to  be  already  large  enough.  The  criterion 
here,  then,  as  in  the  other  cases,  is  simply  cash  dividends,  independ- 
ent of  capitahzation.  On  accounting  principles,  the  cost-of-road 
account  should  include  these  construction  items,  and  the  surplus 
should  show  that  they  have  been  provided  for  out  of  net  earnings. 
Then  a  judgment  of  what  is  a  fair  dividend  could  be  made  with 
full  wisdom  on  the  part  of  all  concerned.  Then,  too,  a  distribution 
of  unexpected  dividend  out  of  secret  reserves  would  be  no  longer 
possible  for  stock  manipulators. 

Of  late  much  discussion  has  arisen  over  the  effect  of  depreciation 
on  reasonable  rates.  Shall  reasonable  return  be  allowed  on  the 
original  cost  of  property  (or  cost  of  dupKcation  new  —  which  is 
the  alternative  of  those  who  repudiate  cost  as  a  basis  for  rates)  or 
on  its  depreciated  cost  (or  value)?  A  corporation  does  not  usually 
need  to  maintain  a  depreciation  fund  large  enough  to  restore  its 
property  to  newness  —  for  renewal  throughout  at  one  time  will 
hardly  happen  ever  to  any  extensive  property.  In  other  words,  the 
normal  operating  condition  is  not  newness  but  partial  exhaustion. 
After  an  enterprise  is  once  well  under  way,  therefore,  a  part  of  its 
capital  is  released  (assuming  no  increase  of  business)  and  may  be 
returned  to  its  stockholders. 

It  has  happened  many  times  that  depreciation  was  not  suffi- 
ciently recognized  in  the  accounts  (and  therefore  was  not  taken  as 
a  cost)  and  hence  profit  was  overstated  —  so  that  a  part  of  the 


GENERAL  PRINCIPLES  OF  CAPITALIZATION  219 

sum  distributed  as  profit  was  in  reality  return  of  capital.  Even  if 
the  community  disclaims  all  responsibility  for  the  loose  accounting 
methods  of  the  past  and  thrusts  the  burden  of  such  errors  of  the 
past  on  owners  of  properties,  it  must  prove  that  the  dividends  of 
the  past  were  large  enough  to  include  both  some  return  of  capital 
and  reasonable  profit  on  capital  remaining  before  it  can  say  that 
in  effect  capital  was  ever  actually  returned.  If  we  say  that  divi- 
dends paid  included  return  of  capital,  and  yet  the  dividends  were 
not  excessive  for  profits  alone,  we  are  saying  that  profits  were  less 
than  a  fair  figure. 

Most  businesses,  moreover,  need  increasing  fi^xed  capital  (in 
normal  growing  American  communities),  so  that  even  on  a  de- 
preciated basis  they  may  need  as  much  capital  as  when  things  were 
new,  — i.e.,  an  increase  in  the  number  of  things  required,  though 
it  is  accompanied  by  a  loss  of  newness  in  most,  keeps  up  the  total 
value  of  property  required  in  use  and  hence  maintains  the  stand- 
ard [page  103].  Many  businesses,  again,  need  increasing  working  or 
current  assets,  and  get  them  from  the  conversion  of  their  fixed  assets. 

Though  the  fixed  assets  may  have  depreciated  from  newness  to 
average  age,  then,  and  may  have  set  free  sums  invested  by  the 
proprietors  (through  the  process  of  normal  conversion  of  fixed 
assets  into  current),  these  liberated  assets  may  have  been  put  to 
any  one  of  three  uses  —  return  to  stockholders,  reinvestment  in  new 
fixed  assets  (replacing  the  loss  of  newness  of  the  old),  or  reinvest- 
ment as  working  capital  (substituted  for  worn-out  fixed  capital). 
The  accounts  should  show  which  has  happened  in  any  specific 
case.  If  the  current  assets  derived  from  wearing  off  the  newness  of 
fixed  assets  have  been  returned  to  stockholders  actually  as  an  ex- 
cess above  a  reasonable  rate  on  their  investment,  the  community 
can  hardly  be  asked  to  pay  rates  high  enough  to  yield  a  reason- 
able return  on  the  original  investment  (unless,  as  may  be  argued, 
the  community  is  as  responsible  as  the  stockholder  for  allowing  the 
returned  capital  of  the  past  to  be  mistaken  for  earnings).  If  the 
current  assets  derived  from  the  conversion  (depreciation)  of  fixed 
assets  have  been  restored  to  the  business,  as  new  fixed  capital,  as 
a  fund  for  renewal,  or  as  working  capital,  they  are  as  much  cost 
and  investment  as  they  ever  were  and  seem  to  be  a  part  of  that 
capital  on  which  earning  should  be  expected. 


220  ACCOUNTS 

If  the  fixed  property  is  carried  on  the  balance  sheet  at  cost,  and 
Allowance  for  Depreciation  (or  that  sort  of  Reserve  for  Deprecia- 
tion which  represents  mere  deduction  from  assets)  is  among  the 
liabihties,  obviously  in  determining  investment  one  should  not 
count  as  total  investment  both  the  current  assets  and  the  book- 
figure  of  the  fixed  assets  (less  Habihty  for  borrowed  funds);  for 
then  some  assets  would  be  counted  twice.  The  Allowance  for 
Depreciation  either  represents  a  deduction  from  fixed  assets  or 
explains  the  origin  of  some  of  the  current  assets;  as  a  matter  of 
fact  it  may  do  both  things,  for  they  may  be  the  same  thing;  hence 
it  may  be  used  to  cancel  proprietor's  investment  in  fixed  or  in 
current  assets,  but  it  cannot  be  used  to  cancel  both.  If,  however, 
the  reported  HabiHty  for  depreciation  is  a  true  reserve,  set  aside 
out  of  earnings  not  distributed  as  dividend  [page  in],  it  does  not 
measure  depreciation;  and  hence  if  rates  were  fair  in  the  past  this 
item  represents  reinvested  profits  on  which  fair  return  may  still 
be  expected. 

To  summarize  this  chapter  in  a  few  words:  the  purposes  of  ac- 
counting are  served  best  by  charging  to  capital  only  actual  costs 
(whether  original  investment  or  reinvested  profits);  and  neither 
overcapitalization  nor  undercapitaHzation  is  a  matter  of  concern 
to  any  one  if  only  actual  costs  are  known  and  are  compared  with 
cash  dividends;  but  the  determination  of  a  reasonable  dividend 
is  quite  as  dependent  upon  a  knowledge  of  risks  taken  as  upon  a 
knowledge  of  the  amoimt  of  actual  investment.  Fortunately  with 
regard  to  most  kinds  of  expenditure  one  does  not  need  to  decide  on 
a  basis  of  capitalization ;  for  the  common  types  of  expenditure  in- 
crease valuations  on  all  three  of  the  bases  of  capitalization  dis- 
cussed in  this  chapter,  in  which  case  they  are  surely  charged  to 
capital,  or  they  increase  valuations  on  no  basis,  in  which  case  they 
are  surely  charged  to  revenue.  An  additional  locomotive,  to  en- 
able a  road  to  run  a  new  train  and  get  new  business,  for  example, 
represents  greater  cost  of  duplication,  greater  earning  capacity, 
and  greater  sacrifice;  but  taxes  paid  on  right  of  way  represent  no 
one  of  these. 


CHAPTER  FOURTEEN 

SOME  GENERAL    PRINCIPLES    ILLUSTRATED    IN   RAILROAD 

ACCOUNTING 

A  RAILROAD  report  is  divided  into  three  parts,  as  follows :  first,  the 
balance  sheet,  or  general  account,  as  it  is  sometimes  called ;  second, 
the  income  sheet,  or  income  account;  third,  the  traffic  report,  or 
statistics.  These  three  parts  are  really  but  one  body  and  should 
hang  together.  The  art  of  interpreting  such  a  report  lies  largely  in 
the  abiUty  to  correlate  the  parts  and  see  whether  they  are  consistent. 
As  a  preparation  for  some  practice  of  that  sort,  it  is  well  to  notice 
the  form  of  the  first  two  of  these  three  parts  of  a  report,  —  the  form 
of  the  last  is  a  matter  largely  of  indifference. 

Every  balance  sheet  contains  at  least  two  parts  for  both  debit 
and  credit,  though  the  classification  of  the  Interstate  Conmierce 
Commission  requires  a  subdivision  of  each  of  these  so  extensive 
that  the  larger  grouping  is  likely  to  be  lost  in  the  details.  The 
first  of  these  divisions  we  may  call  the  capital  part,  containing  all 
capital  items,  —  that  is,  all  items  that  are  permanent ;  and  the  sec- 
ond we  may  call  the  current  part. 

On  the  credit  or  liability  side  of  the  sheet,  these  capital  items  are 
always  at  least  two  in  number,  namely,  capital  stock  and  funded 
debt.  The  first  of  these  is  obviously  permanent,  for  capital  stock 
is  not  a  debt  to  be  paid  but  only  a  liability  to  be  accounted  for,  and 
it  must  endure  as  long  as  the  corporation  endures.  Funded  debt, 
too,  though  ostensibly  of  a  more  or  less  temporary  sort,  always  in 
practice  is  permanent,  for  few  railroads  or  other  corporations  intend 
ever  to  pay  off  their  bonds  and  few  bondholders  care  for  the  pay- 
ment of  the  debt  if  only  they  can  get  their  interest.  Men  ordinarily 
buy  bonds  for  investment,  and  permanence  in  any  investment  is  one 
of  the  valuable  features.  If  the  bonds  must  be  paid,  usually  a  road 
issues  new  bonds  to  pay  for  the  old  or  exchanges  the  old  for  a  new 
issue ;  so  the  debt  itself  is  none  the  less  permanent. 

The  first  capital  item  on  the  debit  side  of  the  balance  sheet  is 


222  ACCOUNTS 

usually  the  "  Cost-of-Road  Account,"  though  it  may  sometimes  bear 
other  titles,  such  as  "Construction  and  Equipment,"  "Franchises 
and  Property,"  "Cost  of  Road  and  Equipment."  That  is  to  say, 
sometimes  equipment  is  reported  as  separate  from  the  road-bed  and 
real  estate,  and  sometimes  it  is  included  with  them.  A  little  observa- 
tion of  the  balance  sheet  should  always  show  what  this  item  is  meant 
to  cover.  The  next  capital  item  on  the  balance  sheet  is  usually  the 
corporation's  ownership  of  stocks  and  bonds  of  other  companies, 
which  may  be  reported  as  one  item  or  as  several ;  commonly  the  item 
or  group  of  items  is  called  "Investments." 

Capital  assets  and  capital  liabilities  are  likely,  for  very  obvious 
reasons,  to  come  somewhere  near  a  balance.  The  purpose  of  issuing 
stock  and  borrowing  money  is  to  construct  and  equip  the  road  or  to 
secure  control  of  other  roads;  so  in  the  nature  of  the  case  a  road 
should  be  able  to  show  in  its  permanent  assets  a  value  practically 
equivalent  to  its  own  stocks  and  bonds  issued.  The  correspondence 
need  not  be  exact,  however,  for  a  road  needs  a  certain  amount  of 
what  is  known  as  "working  capital,"  such  as  stores,  cash,  etc.,  and 
unless  it  has  accumulated  a  surplus  it  cannot  lock  up  all  its  capital 
in  permanent  form.  A  report  is  better  than  it  otherwise  would  be 
if  it  presents  this  relation  between  capital  assets  and  capital  liabili- 
ties so  that  they  can  be  compared  at  a  glance,  distinguishing  them 
from  the  other  figures  of  the  balance  sheet ;  and,  therefore,  if  the  sheet 
is  carefully  made  up,  a  total  of  this  first  portion  of  the  sheet  will  be 
given  before  the  other  items  are  added. 

In  the  second,  or  current,  portion  of  the  balance  sheet  should  be 
included  on  the  debit  side  all  items  that  can  be  readily  converted  into 
cash,  and  on  the  credit  side  all  sums  which  the  road  may  be  called 
upon  soon  to  pay.  A  comparison  of  the  current  assets  with  the  cur- 
rent liabilities  shows  the  immediate  standing  of  the  road,  that  is, 
whether  it  is  likely  to  be  able  or  unable  to  meet  its  immediate  debts. 
For  this  reason  a  report  that  shows  the  current  assets  and  current 
liabilities  so  that  they  can  be  compared  at  a  glance  is  better  than 
one  that  does  not  do  so ;  and,  therefore,  the  total  of  this  portion  of 
the  sheet  should  be  indicated.  Current  assets  should  exceed  current 
liabilities,  for  any  business  with  immediate  resources  of  no  more 
than  its  immediate  liabilities  is  in  a  doubtful  position. 

Profit  and  Loss,  or  Surplus,  is  not  exactly  a  capital  account  in  the 


RAILROAD  ACCOUNTING  223 

ordinary  sense,  for  the  amount  was  never  invested ;  and  yet  it  is  not 
exactly  a  current  account,  for  it  need  not  be  paid  out.  Any  surplus 
which  a  road  has  accumulated  from  its  profits  must  exist  somewhere 
in  either  the  capital  or  the  current  assets,  possibly  in  both ;  and  the 
nominal  account  representing  or  explaining  that  surplus  is  a  liabil- 
ity, for  it  represents  a  responsibility  of  the  road  to  the  stockholders, 
and  this  Hability  grows  as  the  road  gets  richer.  Since  it  is  neither 
capital  nor  current,  it  should  properly  stand  as  an  item  entirely  by 
itself  on  the  credit  or  liabiHty  side.  Then  the  report  shows  plainly 
the  fact  that  the  assets  exceed  the  corresponding  HabiHties  and  the 
excess  measures  the  surplus.  The  same  sort  of  thing,  of  course,  is 
true  of  reserve  funds  and  of  any  other  funds  set  aside  for  a  particular 
purpose  from  accumulated  profits. 

We  may  now  add  still  other  classes  to  our  division  of  the  balance 
sheet.  One  class  desirable  to  show  is  accrued  liabilities  and  re- 
sources, —  to  include  items  not  yet  due  but  already  earned  or  in- 
curred, such  as  rentals,  taxes,  and  interest.  If  interest  or  rent  is 
due  semiannually  on  April  i  and  October  i  and  the  fiscal  year  of 
the  road  ends  June  30,  when  the  road  figures  its  profits  for  the  year 
it  must  count  as  a  cost  the  interest  accrued  for  the  last  three  months 
though  not  due  for  three  months  more.  To  give  an  exact  statement 
of  the  condition  of  a  corporation,  moreover,  one  must  make  allow- 
ance for  interest  even  on  items  bearing  no  interest.  For  example,  if 
the  corporation  has  issued,  on  December  30,  notes  due  in  two  months 
without  interest,  those  notes  are  a  less  serious  liabiHty  than  they 
would  be  if  due  to-day ;  for  either  the  corporation  can  lend  the  money 
in  the  mean  time  or  it  escapes  the  need  of  borrowing.  Similarly, 
a  bill  receivable  due  in  two  months  is  a  less  valuable  asset  than  one 
due  to-day.  If  the  balance  sheet  is  to  be  an  exact  statement  of  the 
business  as  it  stands  on  December  31,  therefore,  allowance  should 
be  made  on  it  for  such  items.  On  the  books,  these  items  would  be 
treated  similarly  to  accrued  items  as  illustrated  in  Chapter  V,  page 
49j  or  in  Appendix  B,  II ;  a  debit  allowance  entered  at  the  close  of 
this  year  would,  when  brought  down  to  the  new  year,  stand  as  a 
credit,  and  would  thus  exonerate  next  year's  interest  account  for 
loss  suffered  by  this  year's  escape  from  interest.  Even  if  next  year 
suffers  no  direct  payments  on  this  score,  it  will  at  least  fail  to  receive 
what  it  should  receive  as  an  inheritance  from  this  year,  and  it  should 


224  ACCOUNTS 

be  credited  with  what  this  year  has  taken  from  it,  —  namely,  the 
use  of  money  which  next  year  should  inherit  at  once.  Since  such  re- 
sources and  liabilities — accrued  and  allowed  interest,  accrued  and 
prepaid  rentals,  accrued  taxes,  etc.  —  belong  in  neither  the  capital 
nor  the  current  classes,  they  may  well  form  a  class  by  themselves. 

Some  roads  also  report  a  class  of  contingent  assets  and  liabilities, 
to  include  items  which  are  not  yet  definitely  decided  but  may  go  for 
or  against  the  road  and  should,  therefore,  show  somewhere  in  a 
statement  of  its  standing.  Such  contingencies  are  bonds  of  subsidiary 
roads  guaranteed  by  the  controlling  road  and  protected,  of  course, 
by  liens  on  the  controlled  roads.  Surely,  if  a  $10,000,000  road 
has  guaranteed  $5,000,000  of  bonds  of  other  roads,  this  fact,  with 
the  security  held  for  the  guarantee,  should  be  shown.  If  a  road 
includes  contingent  items  on  its  regular  balance  sheet,  as  some  roads 
do,  one  who  is  to  judge  the  condition  of  the  road  must  allow  for 
the  fact  that  these  are  contingent  and  may  not  turn  out  as  the  sheet 
indicates  the  expectation  to  be.  To  include  doubtful  items  with  cer- 
tain items  is  to  cast  a  corresponding  doubt  over  the  totals  of  the 
whole  sheet.  It  seems  very  much  wiser,  accordingly,  to  keep  these 
contingent  items  out  of  the  main  body  of  the  balance  sheet  and 
include  them  in  a  supplementary  statement.  One  road,  a  few  years 
ago,  had  on  its  balance  sheet  an  item  of  nearly  $8,000,000  of  con- 
tingent assets  with  no  contingent  liabilities,  and  treated  these  assets 
like  any  others,  while  it  recorded  a  surplus  of  $12,000,000.  It  was 
evident  to  any  one  who  knew  the  nature  of  the  contingent  assets 
that  this  surplus  might  with  the  occurrence  of  the  contingency  shrink 
to  $4,000,000.  This  well  illustrates  the  desirability  of  keeping  such 
items  out  of  the  main  sheet.^ 

The  Interstate  Commerce  Commission  form  of  sheet  follows. 

^  It  is  common  to  carry  doubtful  items  of  bills  receivable  and  accounts  receivable 
to  an  account  called  "Suspense."  The  name  suflnciently  suggests  that,  though  hope 
has  not  been  abandoned  concerning  them,  they  belong  rather  among  the  contingent 
than  the  current  assets.  Other  accounts  with  the  name  "suspense,"  but  of  an  en- 
tirely different  nature,  are  sometimes  found  useful.  These  are  mere  temporary  catch- 
alls,  used  to  receive  items  of  which  the  ultimate  disposition  is  not  yet  known.  For 
example,  on  a  railroad  all  charges  for  a  construction  train  might  be  carried  for  three 
months  to  Construction  Suspense,  and  at  the  end  of  the  time  the  items  might  be  ana- 
lyzed and  then  allocated  to  the  various  accounts  for  construction  and  for  maintenance. 
Such  accounts  are  not  usually  contingent,  but  are  likely  to  relate  to  revenue,  though 
they  may  be  also  for  resources. 


RAILROAD  ACCOUNTING 


225 


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226  ACCOUNTS 

We  may  now  turn  to  the  income  sheet.  An  interesting  form  is 
that  formerly  used  by  the  Interstate  Commerce  Commission,  il- 
lustrated as  follows: 

Gross  earnings  $io5,ooo,cx50.oo 

Operating  expenses  70,000,000.00 

(difference)  Net  earnings  35,000,000.00 

Other  income  10,000,000.00 

(sum)           Gross  income  45,000,000.00 

Fixed  (and  other)  charges  [interest,  taxes,  etc.]  20,000,000.00 

(difference)  Net  income  (available  for  dividend)  25,000,000.00 

Dividend  20,000,000.00 

(difference)  Surplus  for  the  year  $5,000,000.00 

The  term  ''gross  earnings"  is  usually  assigned  to  sums  received 
for  services  rendered,  as  for  passengers,  freight,  mail,  express,  bag- 
gage, storage,  elevators,  stock  yards,  telegraph,  etc.,  just  as  we 
speak  of  a  man's  earnings  as  his  wages,  salary,  or  royalty,  distin- 
guished from  interest  and  dividends  on  his  property.  Some  roads, 
however,  include  in  earnings  dividends  on  any  stock  and  interest  on 
any  bonds  that  they  may  own  in  subsidiary  roads.  This  is  confusing, 
but  is  usually  done  only  when  the  items  are  comparatively  insignifi- 
cant. The  "operating  expenses"  or  "expenses  of  operation"  mean 
practically  always  the  same  thing,  that  is,  the  expenses  incurred  in 
obtaining  the  gross  earnings.  That  is  to  say,  earnings  and  operating 
expenses  relate  to  the  same  thing,  are  really  effect  and  cause.  A  very 
common  method  of  comparison  of  one  road  with  another  is  to  express 
the  relation  between  gross  earnings  and  operating  expenses  in  terms 
of  a  percentage,  as  to  say  that  one  road  is  operated  for  65%  and  the 
other  for  70%,  This  fact  indicates  that  it  is  objectionable  for  any 
road  to  include  dividends  and  interest  in  its  earnings  when  other 
roads  do  not  do  so. 

The  significance  of  net  earnings,  which  is  simply  a  balance,  differs 
between  different  roads  as  that  of  their  gross  earnings  varies.  "  Other 
income"  includes  usually  receipts  from  investments,  land  sales,  etc. 
"  Gross  income,"  being  a  mere  sum,  varies  in  use  only  as  do  the  items 
of  which  it  is  the  sum.  What  most  roads  call  "fixed  charges"  are 
sometimes  called  "first  charges,"  and  the  expression  should  always 
mean  items  which  are  beyond  the  control  of  the  management,  such 
as  taxes,  interest  on  bonds,  and  other  matters  independent  of  opera- 


RAILROAD  ACCOUNTING  227 

tion.  After  fixed  charges  have  been  subtracted  from  gross  income  the 
result  is  the  amount  which  the  company,  if  the  accounts  are  properly 
kept,  has  earned  for  the  period  under  consideration.  This  amount  is, 
of  course,  available  for  dividend ;  and  any  amount  not  so  used  be- 
comes surplus  for  the  year,  —  which,  when  added  to  the  accumulated 
surplus  of  past  years,  appears  upon  the  balance  sheet  in  the  new 
figure  of  surplus. 

This  form  came  to  rather  wide  and  voluntary  adoption  among  the 
railroads  of  the  country,  but  many  roads  still  adhere  to  forms  which 
are  more  or  less  peculiar.  To  each  of  these  pecuHar  forms,  except  so 
far  as  they  enlarge  the  other  form,  some  objection  may  be  made. 
Perhaps  the  worst  of  these  is  as  follows : 

Gross  earnings 

Operating  expenses  and  taxes 
(difference)  Net  earnings 

Other  income 
(sum)  Net  income 

Interest,  rent,  and  dividends 
(difference)  Surplus  for  the  year 

This  is  decidedly  objectionable,  for  it  mingles  things  of  unlike 
nature.  For  example,  though  taxes  are  independent  of  management 
they  are  here  coupled  with  operating  expenses,  and  by  so  much  the 
facts  are  hidden,  —  both  the  effect  of  any  change  in  taxes  and  that  of 
good  or  bad  economy  in  the  management  of  the  road.  Again,  in  this 
statement  net  income  is  not  net,  for  not  all  the  costs  have  been  sub- 
tracted. Interest  and  rents  are  as  much  costs  of  running  the  road  as 
are  operating  expenses,  and  the  income  is  not  net  until  they  have  been 
subtracted;  though,  since  they,  with  taxes,  are  of  a  different  sort 
from  operating  expenses,  they  should  be  distinguished  from  them. 
Finally,  dividends,  which  are  purely  voluntary,  are  not  in  the  class 
with  interest  and  rentals,  —  for  the  latter  are  fixed.  In  the  form  of 
income  sheet  just  given  there  is  no  indication  of  a  comparison  be- 
tween the  amount  available  for  dividends  and  the  dividends  actually 
declared. 

The  form  now  used  by  the  Interstate  Commerce  Commission  is 
an  outgrowth  of  that  given  on  page  226.  The  early  form  did  not 
sufficiently  distinguish  between  the  operations  of  running  a  rail- 


228  ACCOUNTS 

road  and  other  operations  conducted  by  the  same  corporation,  and 
it  did  not  sufficiently  distinguish  between  income  from  outside 
operations  and  income  from  investments.  It  is  interesting  to  ob- 
serve the  nature  of  these  outside  operations.  The  Conmiission  re- 
quires a  separate  group  of  accounts  for  each  of  twenty-one  activi- 
ties tributary  to  rail  operations  but  actually  independent  of  them. 
The  following  are  some  of  them:  boat  lines,  ferry  lines,  electric  rail- 
ways, cab  and  omnibus  service,  sleeping  car  service,  dining  and 
special  car  service,  electric  light  and  power  plants,  grain  elevators, 
hotels  and  restaurants,  amusement  parks  and  resorts,  cold-storage 
plants.  Taxes  on  railway  property  were  formerly  combined  with 
taxes  on  investments.  These  are  now  separated.  Hire  of  equip- 
ment was  formerly  treated  as  an  operating  cost,  but  is  now  either 
"other  income,''or  "deduction  from  other  income,"  according  as 
its  balance  is  favorable  or  unfavorable.  The  separation  of  a  new 
group  of  items  to  show  what  disposition  was  made  of  net  profits 
is  a  decided  advantage  to  the  reader  who  cannot  surely  identify 
such  items  among  the  many  with  more  or  less  imfamiliar  and 
technical  names. 

Though  the  Commission  does  not  attempt  to  prescribe  the  form 
in  which  roads  shall  report  to  their  stockholders  —  requiring  its 
own  form  only  in  reports  to  itself  —  most  roads  have  adopted  in 
their  published  reports  the  form  used  by  the  Commission.  The 
present  form  is  shown  on  the  opposite  page. 

The  Commission  is  attempting  to  secure  complete  knowledge 
regarding  the  practices  affecting  capitalization,  as  discussed  in  the 
last  chapter.  It  forbids,  for  example,  charges  to  be  made  to  capital 
accounts  for  anything  but  increases  in  cost,  and  requires  that  such 
increases  be  so  charged.  Two  decisions  of  the  Commission,  as  cited 
in  its  Accounting  Series,  Circular  No.  12c,  will  show  its  policy: 
"The  effect  of  the  methods  prescribed  for  handling  the  accounts 
is  that  the  'Property  Owned'  account  will,  in  theory,  include  the 
actual  cost  of  all  equipment  owned,  while  the  Replacement  ac- 
count will  represent  the  expired  value  or  depreciation  on  that  equip- 
ment." ^  "It  is  the  purpose  of  this  provision  of  the  Classification 
to  prevent  as  far  as  practicable  the  creation  of  'secret  reserves'  in 
the  future."  ^  It  is  not  always  easy  to  reconcile  the  decisions  of 
1  Page  48.  2  Page  45. 


RAILROAD  ACCOUNTING 


229 


Income  Statement  ^ 
Railway  Operating  Income 
Rail  operations  —  revenue  $ 

Rail  operations  —  expenses 

Net  revenue  —  rail  operations 
Outside  operations  —  revenue 
Outside  operations  —  expenses 

Net  revenue  —  outside  operations 

Net  railway  operating  revenue 
Railway  tax  accruals 

Railway  operating  income 
Other  income 

Income  from  lease  of  road 

Hire  of  equipment  —  credit  balance 

Joint  facility  rent  income 

Miscellaneous  rent  income 

Net  profit  from  miscellaneous  physical  property 

Separately  operated  properties  —  profit 

Dividend  income 

Income  from  funded  securities 

Income  from  unfunded  securities  and  accounts 

Income  from  sinking  and  other  reserve  funds 

Release  of  premiums  on  funded  debt 

Contributions  from  other  companies 

Miscellaneous  income 

Gross  income 

Deductions  from  gross  income 

Deductions  for  lease  of  other  roads 
Hire  of  equipment  —  debit  balance 
Joint  facility  rent  deductions 
Miscellaneous  rent  deductions 
Miscellaneous  tax  accruals 
Net  loss  on  miscellaneous  physical  property 
Separately  operated  properties  —  loss 
Interest  deductions  for  funded  debt 
Interest  deductions  for  unfunded  debt 
Amortization  of  discount  on  funded  debt 
Transfer  of  income  to  other  companies 
Miscellaneous  deductions 

Net  income 

Disposition  of  net  income 
Appropriations  for  sinking  and  other  funds 
Dividends 

Appropriations  for  additions  and  betterments 
Appropriations  for  new  lines  and  extensions 
Stock  discount  extinguished  through  income 
Miscellaneous  appropriations 
Income  appropriated 

Income  balance  transferred  to  Profit  and  Loss 


105,000,000 
70,000,000 

10,000,000 
8,000,000 


$35,000,000 


2,000,000 
37,000,000 

5,000,000 
32,000,000 


500,000 
100,000 
100,000 

2,000,000 
2,500,000 

500,000 
2,000,000 

200,000 


100,000        8,000,000 


3,000,000 
500,000 
700,000 

50,000 
500,000 


8,000,000 
500,000 

1,650,000 
100,000 


3,000,000 

15,000,000 

2,000,000 

3,000,000 

1,000,000 


40,000,000 


15,000,000 
25,000,000 


24,000,000 
1,000,000 


»  These  figures  are  not  for  the  same  road  as  those  of  the  balance  sheet  given  above. 


230 


ACCOUNTS 


the  Commission  to  these  statements  of  theory;  but  some  cases  in- 
volve so  many  interwoven  elements  that  a  practicable  decision  is 
a  compromise  between  detailed  applications  of  theory  that  would 
conflict  if  unadjusted.  Sometimes,  moreover,  the  phraseology  of 
statute  law  involves  accounting  terms  in  senses  so  remote  from 
the  desired  theoretical  accounting  use  of  them  that  only  a  viola- 
tion of  the  theory,  and  acquiescence  in  the  legislative  vocabulary, 
will  protect  business  against  injustice  when  the  laws  come  to  be 
appUed. 

Perhaps  the  best  way  to  illustrate  the  study  of  a  railroad  report 
and  to  show  the  relation  between  its  three  parts  —  namely,  the  bal- 
ance sheet,  the  income  sheet,  and  the  statistics  —  is  to  take  a  specific 
case  of  railroad  history  and  see  how  far  the  condition  ultimately 
resulting  could  have  been  foreseen  from  the  reports  of  a  few  years 
earlier.  For  this  purpose,  of  course,  it  is  desirable  to  take  a  closed 
incident.  One  of  the  best  illustrations  is  the  history  of  the  Atchison, 
Topeka  &  Santa  Fe  Railroad  between  its  reorganization  in  1889 
and  its  bankruptcy  in  1893. 

From  the  reports  of  the  road  for  that  period  we  can  obtain  figures 
as  follows : 


Cost  of  Road 

Investments                              Capital  Stock 

Funded  Debt 

(millions) 

(millions) 

(millions) 

(millions) 

•90 

$81.0 

S212.4 

$90.9 

$2188 

'91 

86.6 

219.0 

99-5 

220.8 

■92 

913 

225.6 

99.9 

223.3 

'93 

96.0 

230.4 

101.8 

228.1 

Accounts  and 

Accounts  and 

Advances  to  Sub- 

Cash 
(millions) 

Surplus 
(millions) 

Bills  Receivable 
(millions) 

Bills  Payable 
(millions) 

sidiary  Companies 
(millions) 

•90 

$S.o 

$2.8 

$50 

$6.3 

$0.7 

'91 

7.2 

89 

61 

40 

23 

'92 

6.1 

10.8 

7-7 

4-5 

45 

'93 

9-4 

12.4 

8.3 

4.2 

77 

Gross  Earnings 

Gross  Earnings        Operating  Expenses 

Net  Earnings 

Net  Earnings 

(millions) 

per  mile 

(millions) 

(millions) 

per  mile 

'90 

$31-0 

$4,335 

$20.9 

$10.1 

$1,472 

'91 

33-^ 

4,733 

24.0 

9.6 

1,353 

'92 

36.4 

5»ii4 

25  2 

II. 2 

1,576 

'93 

41.3 

5,523 

28.6 

12.7 

1,699 

I 


RAILROAD  ACCOUNTING 


231 


Revenue  Trains 

Operating 
Ratio 

Miles 

Earn 

lings 

Operating  Expc 

nses           Net  Earnings 

(millions) 

per 

mile 

per  mile 

per  mile 

'90 

22.3 

$1 

•39 

$094 

$0.45 

68% 

'91 

25.2 

I 

33 

095 

0.38 

71% 

'92 

26.3 

I 

•38 

0.96 

0.42 

70% 

•93 

295 

I 

.40 

0.97 

043 

69% 

Maintenance  of  Way 
per  mile 

Maintenance  of  Equipment  per  Mil< 

;  Run 

Locomotives 

Passenger  Cars 

Freight  Cars 

•90 

$633 

$0. 

043 

$00059 

$0.0043 

'91 

717 

0 

050 

0.0071 

0.0047 

•92 

645 

0. 

055 

0.0097 

00055 

•93 

741 

0. 

.052 

0.0090 

0.0059 

Average  Mileage 

Number  of 

Av 

erage  Locomotive 

Average 

of  Freight  Cars 

Freight  Cars 

Mileage 

Train  Load 

'90 

11,402 

23: 

.013 

32,550 

121  Tons 

•91 

10,242 

27,914 

34,294 

112        •' 

•92 

10,200 

30 

,803 

36,112 

119        " 

•93 

10,135 

32 

,626 

36,110 

122        " 

Income  from 
Investments 
(millions) 

Interest 

(millions) 

Net 

Income 

(millions) 

■90 

1 

1 

1 

■91 

So  5 

$5- 

5 

$15 

>92 

0.5 

6 

0 

2.0 

•93 

0.5 

8 

■7 

1.9 

Not  all  these  figures  were  published  by  the  road  itself,  unfortu- 
nately. Many  of  them  we  can  get  only  by  combining  other  figures 
published.  For  example,  the  road  does  not  publish  its  average 
freight-car  mileage.  This  we  obtain  by  dividing  total  freight-car 
miles  by  the  number  of  freight  cars  reported  in  the  equipment.  This 
may  not  give  absolutely  accurate  results,  for  foreign  cars  and  Atchi- 
son cars  on  foreign  fines  should  be  considered ;  but  since  our  pur- 
pose is  chiefly  to  compare  years,  the  method  is  fair.  The  average 
train-load  is  not  given :  this  we  get  by  dividing  tons  carried  one  mile 
by  the  number  of  freight-train  miles.  Cost  of  maintenance  per  mile 
run  is  given  only  for  locomotives :  the  other  figures  are  obtained  by 
dividing  the  debits  to  several  accounts  under  the  operating  expenses 
by  the  number  of  each  kind  of  equipment.  The  difi5culty  of  obtain- 

^  Reported  for  nine  months  only. 


232  ACCOUNTS 

ing  correct  figures  is  increased  by  the  fact  that  the  road  reports  some 
items  for  the  consolidated  system  and  others  for  the  Atchison  system 
proper. 

It  is  desirable  to  begin  our  examination  with  income.  We  find 
gross  earnings  increasing  satisfactorily.  The  total  increase  is  of  no 
importance,  however,  unless  it  bears  a  correct  relation  to  the  mileage 
of  the  road ;  for  a  road  adding  new  mileage  without  adequate  increase 
in  traffic  is  weakened.  We  next  find  our  gross  earnings  per  mile  to  be 
also  increasing  steadily. 

We  turn  next  to  operating  expenses.  These  in  189 1  had  increased 
much  faster  than  earnings.  This  increase  was  explained  in  the  text 
of  the  report  as  due  to  increased  traffic  expenses,  and  to  heavy 
maintenance  charges  consequent  upon  the  overburdening  of  rolling 
stock  of  the  year  before.  These  explanations  are  not  convincing.  Let 
us  examine  them  in  detail.  Though  heavy  traffic  would  increase 
operating  expenses,  it  should  not  increase  them  in  greater  measure 
than  that  of  the  increase  of  traffic.  We  find,  however,  that  though 
earnings  had  increased  a  little  over  8%,  and  ton  miles  only  4^% 
(1,769,000  tons  to  1,844,000  tons),  the  cost  of  labor  for  transporta- 
tion has  increased  24%  ($4,300,000  to  $5,400,000),  the  cost  of  fuel 
has  increased  15%  ($2,400,000  to  $2,800,000),  and  the  expense  of 
foreign  agencies  has  increased  53%  ($294,000  to  $449,000).  The 
increase  in  the  cost  of  labor  might  have  been  due  to  an  increase  in 
the  rate  of  wages,  but  no  evidence  of  this  appears.  We  find,  on  the 
other  hand,  evidence  of  poor  economy  in  management  in  the  fact  that 
the  average  train-load,  very  light  even  in  1890,  falls  7J%  in  1891. 
The  company  attempts  to  explain  this  by  the  extraordinary  demands 
upon  the  rolling  stock,  but  it  does  not  explain  how  Hghter  loads  in- 
crease efficiency.  Though  locomotives  were  driven  farther,  freight 
cars  traveled  a  shorter  average  distance.  The  greater  cost  of  fuel 
cannot  be  due  to  a  higher  price,  for  the  price  paid  for  coal  is  given 
in  the  report  as  2%  lower  in  '91  than  in  '90,  and  wood  as  only  i  J% 
higher  —  insignificant  in  comparison  with  an  increase  of  15%  in 
fuel  cost.  Maintenance  of  equipment,  though  costlier  than  in  1890, 
was  below  what  it  became  in  subsequent  years  and  far  below  what  it 
should  have  been.  In  other  words,  the  attempt  to  explain  away  the 
increase  of  operating  expenses  over  the  increase  in  receipts  for  1891 
merely  emphasizes  the  poor  economy  of  the  management.  This  is 


RAILROAD  ACCOUNTING  233 

confirmed  by  the  statistics  for  revenue  trains.  Though  gross  earnings 
of  the  road  increased,  the  earnings  per  train  mile  decreased  —  show- 
ing excessive  running  of  trains  for  the  traffic.  Operating  expenses 
per  train  mile,  moreover,  actually  increased.  So  a  double  loss  was 
suffered  in  train  operation.  There  should  have  been  a  gain ;  for  the 
rates  for  transportation,  as  shown  by  the  report,  had  risen  (the  aver- 
age passenger  fare  per  mile  rose  from  2.234  cents  to  2.357,  and  the 
average  freight  charge  per  ton  mile  rose  from  1.228  cents  to  1.265). 

Taking  our  four  years  as  a  whole,  however,  we  find  a  fairly  steady 
growth  of  gross  earnings,  net  earnings,  and  net  earnings  per  mile. 

Our  next  problem  is  to  determine  whether  the  earnings  are  real. 
The  first  inquiry  is  about  the  adequacy  of  maintenance  charges.  The 
maintenance  of  way  charge,  varying  from  $633  to  $735,  is  very  low. 
The  Atchison  road  is  favored  by  its  location,  and  of  course  it  has  a 
single  track  line;  but  it  is  hard  to  believe  that  the  road  could  be 
kept  in  good  condition  at  the  cost  shown  here.  Rails  cannot  ordi- 
narily be  counted  upon  to  last  more  than  twenty  years ;  a  road  should 
therefore  relay  about  one  twentieth  of  its  line  (or  more)  each  year. 
The  Atchison  took  three  years  to  relay  one  twentieth  ('91,  152  miles; 
'92,  93  miles;  '93,  118  miles).  The  Southern  Pacific,  in  the  same 
years  that  the  Atchison  was  spending  an  average  of  $684  per  mile  for 
maintenance,  was  spending  an  average  of  $1083,  and  it  was  not  then 
as  now  accumulating  a  large  reserve  of  betterments.  The  average  for 
the  Northern  Pacific,  the  Southern  Pacific,  and  the  Union  Pacific, 
combined,  wai  for  these  years  $982.  The  figures  for  maintenance 
of  equipment  are  also  extremely  low.  The  average  American  main- 
tenance for  locomotives  is  about  seven  cents  per  mile  run ;  for  pas- 
senger cars,  one  cent ;  for  freight  cars,  six  mills.  The  figures  for  the 
Atchison  show  locomotive  maintenance  wholly  inadequate,  and  car 
maintenance  adequate  only  in  the  last  two  of  the  four  years.  Does 
this  explain  why  the  loads  were  light  and  expense  of  hauling  heavy  in 
1891? 

Before  proceeding  with  the  other  items  of  income  we  had  best 
investigate  the  balance  sheet,  to  see  whether  any  assets  should  have 
been  charged  against  revenue.  Cost  of  Road  shows  a  steady  increase, 
of  practically  five  million  dollars  a  year.  This  is  not  mainly  for  new 
mileage,  for  the  average  mileage  figures  given  in  the  report  run  as 
follows:  7111,  7112,  7124,  7480.  These  figures  of  mileage  are  con- 


234  ACCOUNTS 

fusing.  In  the  report  for  1892  the  mileage  is  given  as  7124;  but  in 
that  for  1893  it  is  given  as  7480,  "  an  increase  of  six  miles  over  1892.'' 
That  is  to  say,  the  Colorado  Midland  is  omitted  from  the  figures 
for  1892  in  the  1892  report,  but  is  included  in  the  figures  for  1892  in 
the  1893  report.  Such  discrepancies  make  a  great  deal  of  extra  labor 
for  any  one  studying  the  figures,  for  they  are  not  explained.  The 
only  considerable  increase  in  mileage  to  account  for  the  increase  in 
Cost  of  Road  is  in  1893,  but  only  six  miles  of  this  belongs  to  the 
Atchison,  for  the  Colorado  Midland,  the  other  350  miles,  is  repre- 
sented among  the  assets  by  its  stock  held  and  is  not  consolidated 
with  the  Atchison  mileage  except  for  operating  purposes.  We  have, 
then,  to  explain  about  five  million  dollars  annual  increase  in  cost 
of  road  practically  without  increase  of  mileage.  The  report  shows 
charges  to  construction  and  equipment  for  improvements  and  increases 
as  follows  (in  milUons) :  2.7,  3.5,  2.2.  How  shall  we  find  the  rest  of 
the  annual  five  million  ?  We  should  Hke  to  put  that  question  to  the 
accounting  officers  of  the  road.  No  trace  of  it  appears.  There  is,  on 
the  other  hand,  what  looks  hke  an  attempt  to  hide  the  fact  that  there 
is  a  discrepancy.  Each  year's  balance  sheet  begins  with  an  item  of 
"Franchises  and  Property,"  and  adds  to  it  the  "Property  Additions 
during  the  Year" ;  then  the  total  is  carried  out  as  the  first  main  item 
of  the  balance  sheet.  The  "Property  Additions"  correspond  prac- 
tically with  a  detailed  table  of  "Amounts  charged  to  Construction, 
Improvement,  and  Equipment."  This  should  mean  that  the  initial 
item  is  brought  over  from  the  last  year  and  the  new  items  are  added. 
When  we  test  this,  however,  we  find  that  the  initial  item  each  year  is 
much  larger  than  the  final  item  of  the  year  before.  To  illustrate,  in 
1890  the  initial  figure  for  property  was  $80,105,002,  to  which  addi- 
tion was  made  of  $930,014,  giving  a  final  item  of  $81,035,016.  In 
1891,  however,  the  initial  figure  was  $83,912,568,  to  which  addition 
was  made  of  $2,748,952,  giving  a  final  total  of  $86,661,520.  So  far  as 
any  one  can  see,  all  proper  charges  to  cost  of  road  and  equipment 
are  included  in  the  item  of  two  and  three  quarters  millions  added  to 
the  eighty- four  miUions.  But  whence  came  that  eighty- four  milhons  ? 
The  final  item  of  the  year  before  was  only  eighty-one  millions,  and 
no  possible  reason  for  increasing  it  except  new  construction  already 
accounted  for  in  the  two  and  three  quarters  milhons  is  apparent. 
Only  when  one  compares  the  balance  sheets  of  two  years,  with  an 


RAILROAD  ACCOUNTING  235 

attempt  to  account  for  changes,  does  this  discrepancy  appear.  What 
does  it  mean? 

The  item  of  investments  should  be  examined  next.  The  Atchison 
does  not  show  its  valuation  of  investments  in  detail,  but  gives  the  par 
value  of  each  holding  and  shows  the  ledger  valuation  of  the  total 
holdings.  The  increase  in  the  first  year,  as  shown  by  detailed  tables, 
is  practically  the  same  as  the  increase  in  holdings  of  St.  Louis  &  San 
Francisco  stock  at  par.  This  does  not  necessarily  indicate  that  the 
St.  Louis  &  San  Francisco  stock  has  been  valued  at  par,  of  course,  for 
other  stocks  may  have  risen  in  value  during  the  period ;  but  one  or 
the  other  of  these  things  must  have  happened.  Let  us  examine  this 
matter.  The  chief  holding,  in  the  class  of  investment  showing  an  in- 
crease, besides  the  St.  Louis  &  San  Francisco,  is  stock  in  the  Atlantic 
&  Pacific  Railroad.  For  the  year,  the  St.  Louis  &  San  Francisco 
showed  an  actual  deficit  of  expenses  over  earnings  (I  of  1%),  and  the 
Atlantic  &  Pacific  showed  a  deficit  of  almost  3%.  It  seems  a  little 
peculiar  either  to  value  the  stock  of  the  former  at  par  or  to  increase 
the  valuation  of  the  latter  above  its  value  a  year  before  when  each 
had  earned  so  trifling  a  sum.  There  is  a  consideration,  however,  on 
which  the  stock  in  a  non-paying  road  may  be  very  valuable  to  a 
controlling  road.  If  the  subsidiary  road  is  a  feeder,  and  brings  to  the 
controlling  road  much  traffic  on  which  the  latter  earns  for  long  hauls, 
the  gain  on  the  extra  through  traffic  may  more  than  offset  the  loss  of 
dividend  on  the  stock.  So  the  holding  of  stock  which  gives  control 
may  be  worth  par  to  the  controlling  company.  One  other  considera- 
tion, moreover,  is  necessary.  The  controlling  road  of  course  divides 
the  rate  on  through  traffic  between  the  two  roads.  If  this  rate  is 
divided  arbitrarily,  rather  than  scientifically,  the  auxiliary  road  may 
appear  to  be  run  at  a  loss  when  in  reaHty  a  just  division  of  rates 
would  give  it  a  part  of  the  earnings  of  the  controlling  road.  Indeed, 
so  far  as  the  controlling  road  owns  less  than  all  the  stock  of  the  other, 
it  will  find  profit  in  an  unfair  division  of  the  rate ;  for  all  that  it  takes 
unfairly  goes  into  its  own  coffers,  whereas  what  it  allows  to  the  other 
must  be  divided  with  other  stockholders.  We  cannot  be  sure,  there- 
fore, what  is  the  exact  meaning  of  this  increase  in  investment  holdings 
on  the  balance  sheet  for  1891. 

The  next  year  sees  a  similar  transaction  with  stock  of  the  Colorado 
Midland,  which  was  rapidly  accumulating  a  deficit  (3%  for  1892). 


236  ACCOUNTS 

The  report  for  the  next  year  gives  a  repetition  with  more  stock  of  the 
St.  Louis  &  San  Francisco,  which  is  now  nominally  earning  one  per 
cent,  but  still  facing  a  growing  deficit  because  of  unprofitable  rela- 
tions with  other  roads.  To  summarize  these  investments  of  the 
Atchison,  then,  we  conclude  that  they  are  distinctly  worth  less  than 
the  balance  sheet  figures  unless  the  control  connected  with  them  is 
of  great  value.  This  seems  very  improbable,  however,  for  we  find 
that  even  the  Atchison's  own  figures  give,  with  the  help  of  these 
feeders,  a  net  income  of  only  two  per  cent. 

We  have  found  a  total  increase  of  capital  assets  on  the  balance 
sheet  of  thirty-three  milUons,  fifteen  millions  in  Cost  of  Road  and 
eighteen  millions  in  Investments.  Twenty-one  millions  of  this  in- 
crease in  assets  has  been  secured  by  funds  raised  by  increasing 
Funded  Debt  and  Capital  Stock.  We  have  twelve  millions  still  to 
account  for.  The  increase  in  Accounts  and  Bills  Payable  provides 
for  nine  and  a  half  millions,  and  the  decrease  in  cash  for  the  re- 
main-^er.  Two  items  of  assets  remain,  and  we  find  their  increase 
exactly  equivalent  to  the  surplus.  In  proportion  as  this  increase  is 
good,  then,  the  surplus  will  be  good.  Accounts  and  Bills  Receivable 
have  nearly  doubled  in  three  years.  But  have  they  not  increased  too 
fast?  In  1893,  gross  earnings  increased  but  13%:  this  item  has 
increased  54%.  Would  such  a  road  willingly  allow  nearly  ten  mil- 
lions to  be  tied  up  in  such  accounts,  —  the  equivalent  of  one  tenth 
of  its  Cost  of  Road  ? 

The  advances  to  subsidiary  roads  raise  a  new  problem.  These 
advances  are  chiefly  ($7,800,000  out  of  $8,300,000)  to  the  Atlantic 
&  Pacific  Railroad  and  the  St.  Louis,  Kansas  City  &  Colorado 
Railroad.  What  is  the  probability  of  repayment?  The  Atlantic  & 
Pacific,  as  already  stated,  was  accumulating  a  deficit.  This  in  1893 
was  16%  of  its  capital  stock  ($12,502,432  deficit  on  a  capital  stock 
of  $79,760,300).  The  other  road  had  accumulated  a  deficit  of  74% 
of  its  capital  stock  ($1,187,370  deficit  on  $1,600,000  capital  stock). 
To  count  such  advances  as  good  is  to  take  a  very  hopeful  view  of 
the  future.  Here  are  sums  larger  than  the  whole  Atchison  surplus, 
and  no  prospect  appears  that  they  will  ever  be  worth  anything.  It 
may  be  true  that  the  advances  to  these  roads  gave  good  earnings  to 
the  Atchison,  by  stimulating  joint  traffic,  or  it  may  be  true  that  the 
Atchison  through  its  division  of  the  rate  prevented  these  roads  from 


RAILROAD  ACCOUNTING  237 

earning  anything.  In  such  a  case  the  advances  would  be  justified 
as  good  business  policy ;  but  how  should  they  be  recorded  on  the 
books  ?  Not  surely  as  assets,  but  as  costs  of  getting  business.  They 
should  be  included  in  expenses  on  the  income  sheet,  and  there  be 
taken  out  of  profits.  They  have  no  relation  properly  with  assets. 
We  must,  therefore,  at  a  sweep,  if  we  are  to  show  Atchison  affairs 
as  they  were,  write  off  this  item  and  with  it  the  surplus.  Indeed, 
this,  with  a  reasonable  degradation  of  Accounts  and  Bills  Receiv- 
able, would  produce  a  considerable  deficit. 

Of  the  remaining  items  not  much  needs  to  be  said.  The  income 
from  investments,  as  we  may  well  suspect,  is  ridiculously  small,  — 
less  than  one  quarter  of  one  per  cent.  The  charge  to  interest  is  de- 
pendent chiefly  on  the  funded  debt,  of  course.  Here  it  increases 
more  rapidly  because  under  the  reorganization  of  1889  interest 
payments  were  to  increase  with  earnings  until  a  certain  maximum 
rate  should  be  attained.  The  net  income  is  simply  a  balance ;  but 
now  that  we  have  seen  that  advances  to  other  companies  was  wrongly 
counted  as  an  asset,  we  should  write  down  this  net  income  to  the 
following  figures:  1891,  $400,000;  1892,  $400,000;  1893,  $1,300,000. 
The  failure  of  surplus  to  follow  net  income  (no  dividends  were  paid) 
is  due  to  the  inclusion  of  the  operations  of  subsidiary  lines  in  operat- 
ing figures,  but  not,  of  course,  in  figures  for  the  balance  sheet. 

Our  summary  of  the  situation,  then,  is  discouraging.  Earnings 
are  steadily  increasing,  but  practically  every  other  element  is  doubt- 
ful or  distinctly  unfavorable. 

Let  us  look  for  a  moment  at  the  road's  solvency.  In  the  first  year, 
current  assets  were  eleven  and  a  third  million  dollars  against  eight 
million  current  and  accrued  habilities,  of  which  more  than  five  million 
was  for  interest  and  taxes.  In  1891,  the  relation  between  these  was 
reversed :  eleven  million  to  fourteen  million.  At  this  time  the  road 
reported  as  among  current  assets  in  addition  to  the  figure  given  above 
over  six  million  of  treasury  securities  '*  available  for  payment  of 
current  obligations."  To  use  these  for  such  purpose,  of  course,  would 
be  to  convert  current  liabilities  into  capital  liabilities ;  and  therefore 
in  a  sense  the  arrangement  of  the  balance  sheet  is  misleading.  For 
1892,  the  relation  was  eleven  milUon  to  sixteen  and  a  half  million, 
with  seven  million  in  treasury  obHgations  available  to  add  to  the 
eleven  if  necessary.   For  1893,  we  find  thirteen  and  a  half  against 


238  ACCOUNTS 

sixteen  and  three  quarters,  with  seven  million  and  a  half  available 
treasury  obligations.  In  other  words,  only  by  considering  treasury 
bonds  and  notes  as  current  assets  could  the  road  show  after  1890 
current  funds  to  guarantee  payment  of  its  current  liabilities. 

It  is  now  interesting  to  see  what  was  the  opinion  in  financial 
centres  concerning  the  condition  of  the  Atchison.  On  December  9, 
1893,  the  ''Commercial  and  Financial  Chronicle,"  the  best-known 
financial  paper  in  the  country,  said  that  the  last  annual  report  of 
the  Atchison  showed  current  assets  of  a  million  and  a  half  more 
than  current  liabilities,  and  that  the  earnings  to  October  i  were 
enough  to  pay  the  three  months'  proportion  of  the  charges  and  leave 
a  good  surplus.  "Statistical  analysis  gives  no  warrant  for  unfavor- 
able rumors,"  it  said. 

Just  two  weeks  later  the  Atchison  asked  for  the  appointment  of  a 
receiver,  on  the  ground  that  the  road  could  not  meet  its  approaching 
January  interest.  One  explanation  was  that  the  season  was  unfa- 
vorable for  selling  bonds.  In  other  words,  not  all  the  assets  reported 
as  current  were  available.  A  committee  of  reorganization  was  chosen 
soon  afterward.  This  committee  selected  an  expert  accountant  to  go 
over  the  books  and  report  on  both  the  balance  sheet  and  the  income 
sheet.  When  the  report  of  this  accountant  was  published,  the  finan- 
cial world  was  simply  astounded.  In  fact,  this  report  in  some  degree 
marked  the  beginning  of  a  new  era  in  railroad  accounting.  The 
results  of  the  disclosures  showed  railway  managers  how  the  public 
looked  upon  careless  accounting,  and  showed  investors  how  better 
to  watch  railroad  earnings,  expenses,  assets,  and  liabilities. 

The  report  of  the  examining  accountant  stated  that  errors  and 
misstatements  had  been  made  in  the  reports  of  the  Atchison  Rail- 
road. It  is  interesting  to  examine  some  of  the  items  in  detail. 
Nearly  $4,000,000  was  rebates  to  shippers.  This  was  really  direct 
cost  of  obtaining  business,  and,  therefore,  should  have  been  de- 
ducted from  earnings.  This  amount  stood  on  the  books  as  an  asset 
under  the  ledger  heading  "Auditor's  Suspended  Accounts,  Special," 
though  it  had  no  value  whatever.  On  the  balance  sheet  this  account 
had  been  combined  with  others,  and  so  could  not  be  identified  by 
an  outsider;  and  this  account,  moreover,  had  been  credited  in  1891 
with  over  $1,500,000,  which  had  been  transferred  to  "Franchises 
and  Property,"  thus  including  in  the  cost- of- road  account  an  item 


RAILROAD    ACCOUNTING  239 

purely  fictitious.  We  found  some  time  ago  that  the  increase  in 
Cost  of  Road  was  without  apparent  reason,  and  this  milHon  and  a 
half  is  no  doubt  a  part  of  it.  The  road  had  another  "Auditor's 
Suspended  Account,"  of  over  $2,750,000,  which,  to  quote  the  report, 
had  been  "credited  from  time  to  time  to  the  earnings  and  expenses 
respectively,  but  which  credit  had  no  foundation  in  fact."  Another 
item  of  over  $300,000  counted  as  an  asset  was  really  nothing  but  an 
uncollectible  balance  from  a  dissolved  pool.  This  was  a  mere  claim 
against  other  roads  which  the  other  roads  had  declared  unwarranted 
and  had  refused  to  pay ;  yet  for  purposes  of  the  Atchison  bookkeeping 
it  was  a  good  asset.  Operating  expenses  had  been  wrongly  credited 
with  $500,000,  which  had  been  transferred  to  capital  account. 
Cash,  which  had  been  reported  as  a  little  over  $3,000,000,  was  really 
less  than  $2,500,000,  the  balance  being  bad  "cash  items."  Bills 
Payable,  though  reported  at  less  than  $7,000,000,  had  been  really 
nearly  $8,750,000.  Accounts  Receivable,  reported  at  $6,000,000, 
were  really  only  a  trifle  over  $4,250,000.  These  last  three  items  alone 
give  a  deficit  of  $4,000,000.  So  much  for  so-called  assets  that  were 
worthless. 

Now  let  us  look  at  earnings.  Equipment  to  the  amount  of  nearly 
$1,250,000  had  been  worn  out  and  not  replaced  in  the  four  years 
ending  1893.  The  other  income,  small  though  it  was,  had  been  re- 
ported in  the  last  three  years  more  than  a  million  in  excess  of  the 
actual  figure.  The  interest  charge  on  the  funded  debt  had  been 
understated  by  nearly  $650,000,  the  difference  being  certain  worth- 
less offsets  which  the  road  had  called  good. 

It  is  notable  that  all  these  misstatements  were  on  matters  about 
which  the  outsider  could  get  no  information  from  the  reports.  When 
to  the  losses  hidden  by  these  misstatements  one  adds  those  which 
we  have  already  read  from  the  reports  themselves,  one  is  not  sur- 
prised at  the  Atchison  bankruptcy. 

It  is  believed  that,  though  many  railroad  reports  of  to-day  leave 
facts  buried  from  the  unskillful  reader,  or  misinterpreted  by  op- 
timism, few  contain  actual  misstatements  of  clear  fact  as  did  the 
Atchison  reports  between  the  reorganization  of  1889  and  that  of 
1895.  After  the  latter  reorganization  the  road  became  conspicuous  as 
a  leader  in  the  movement  for  an  improved  form  of  report  signed  by 
a  firm  of  professional  accountants.  It  is  true  even  to-day,  however. 


240  ACCOUNTS 

that  with  even  the  best  form  of  report  and  the  most  detailed  and 
truthful  statement  of  facts,  a  person  desiring  to  read  railroad  opera- 
tions inteUigently  must  learn  the  language  in  which  reports  are 
written,  —  must  see  how  the  different  elements  of  each  part  of  a 
report  are  related  to  the  others,  that  is,  must  learn  to  read  between 
the  lines. 

What  is  true  of  railroads  is  true  to  great  extent  of  all  lines  of  busi- 
ness. Certain  relations  should  exist  between  capital,  revenue,  pro- 
duction, and  costs.  The  accounts  should  be  so  kept  that  the  actual 
relations  may  be  seen ;  but  no  man  is  really  competent  to  judge  of 
the  status  of  a  business  or  of  the  value  of  an  investment  unless  he 
can  read  between  the  lines  of  published  reports  and  see  the  meaning 
of  the  facts  presented,  —  and  this  can  be  done  only  by  careful 
analyses  and  comparisons. 


CHAPTER  FIFTEEN 

ACCOUNTING    IN   REORGANIZATIONS 

As  good  an  illustration  as  we  can  find  for  the  principles  underlying 
the  application  of  accounts  to  reorganizations  is  afforded  by  the  two 
reorganizations  of  the  Atchison,  Topeka  &  Santa  ¥6  Railroad  men- 
tioned in  the  last  chapter.  It  is  desirable  to  get  as  a  preliminary  to  a 
study  of  them  a  view  of  the  commoner  kinds  of  bonded  indebted- 
ness. 

The  most  common  form  of  such  indebtedness  is  the  mortgage 
bond,  which  provides  by  way  of  security  that  on  failure  of  the  borrow- 
ing corporation  to  meet  its  indebtedness  the  lender  may  seize  the 
property.  A  general  mortgage  bond  will  include  a  right  to  seize 
practically  the  whole  property  of  the  corporation,  but  special  terms 
may  provide  that  only  specific  named  property  shall  be  subject  to  the 
mortgage.  When  the  funds  raised  under  a  mortgage  have  been  ex- 
hausted and  it  becomes  necessary  to  raise  more,  it  may  be  possible 
to  issue  second-mortgage  bonds  upon  the  same  property.  These 
give  a  claim  upon  the  property  enforcible  only  after  the  claims  of 
all  holders  of  first-mortgage  bonds  have  been  satisfied.  Such  bonds, 
then,  are  Hkely  to  meet  with  a  sale  only  when  the  first  mortgage  is  in 
amount  considerably  below  the  recognized  value  of  the  property. 
In  some  cases  even  a  third  mortgage  may  be  issued,  its  value  being 
practically  nothing  unless  the  claims  of  the  first  two  sets  of  mortgages 
are  more  than  covered. 

An  income  bond,  unlike  the  mortgage  bond,  gives  no  security  in 
the  property  of  the  corporation.  It  is  a  claim  upon  the  corporation's 
income  only.  If  income  is  not  earned,  the  holder  of  the  bond 
has  no  recourse.  If  it  is  provided  in  the  terms  of  the  bond  that  the 
claim  to  income  shall  be  cumulative,  defaulted  interest  in  bad  years 
must  be  made  up  from  the  earnings,  when  large  enough,  in  the 
subsequent  year  or  years;  and,  of  course,  payment  for  interest  on 
income  bonds  must  be  made  before  any  dividend  can  be  paid,  but 


242  ACCOUNTS 

is  not  to  be  made  until  after  all  interest  upon  mortgage  bonds  has 
been  paid. 

Another  form  of  bond,  less  common  in  this  country  than  abroad, 
is  the  so-called  debenture.  In  one  sense  this  is  hardly  a  bond  at  all, 
but  is  merely  a  promise  of  the  corporation ;  for  no  specific  property 
or  income  is  attachable  as  security  for  the  payment. 

A  specific  form  of  mortgage  bond  that  has  come  into  prominence 
of  late  years  is  the  so-called  equipment  or  car-trust  bond.  This 
sort  of  bond  is  usually  issued  in  series,  payable  at  yearly  intervals, 
and  allows  a  railroad  to  pay  for  its  equipment  on  the  installment 
plan.  The  peculiar  feature  is  that  the  title  to  equipment  bought 
from  the  proceeds  of  such  bonds  remains  with  the  lenders  until  the 
debt  is  paid.  Thus  the  bondholders  are  secured  by  a  claim  that  takes 
priority  over  even  general  mortgage  bonds  —  but  only  to  the  extent 
of  the  specific  equipment  bought  with  the  money. 

Another  recent  development  in  bond  issues  is  the  collateral  trust 
bond.  This  practically  always  originates  from  the  combination  of 
various  corporations,  so  that  one  chief  corporation  holds  and  ad- 
ministers the  property  of  several  minor  ones.  The  chief  corporation, 
in  order  to  raise  means  to  control  the  inferior  ones,  deposits  with 
trustees  stock  or  bonds  of  these  inferior  companies  as  collateral, 
and  with  the  funds  raised  carries  on  its  purchase  or  control  of  addi- 
tional stocks  and  bonds.  The  trust  in  this  case  is  simply  a  security 
that  the  money  loaned  shall  be  put  to  the  use  specified  and  that 
the  stocks  and  bonds  of  inferior  companies  shall  be  kept  intact 
as  security  for  the  principal  loaned.  The  name  "collateral  trust '* 
very  well  indicates  the  form  of  the  condition.  The  trustee  is  usually 
a  trust  corporation,  and  the  bonds  and  stocks  of  the  inferior  com- 
panies are  usually  deposited  in  its  care. 

Though  various  other  sorts  of  bonds  are  upon  the  market,  the 
only  one  of  which  the  name  does  not  sufficiently  indicate  the  nature 
is  the  prior-lien  bond.  This  is  issued  only  under  unusual  conditions, 
for,  as  the  name  suggests,  a  prior-lien  bond  issued  late  takes  prece- 
dence of  all  earlier  bonds.  The  best  illustration  of  this  is  the  issue 
of  bonds  by  a  receiver  for  a  bankrupt  corporation  to  raise  money 
for  continuing  the  business.  In  this  case  what  has  happened  is  that 
the  courts  have  intervened  to  protect  claimants,  and  the  loan  of 


ACCOUNTING  IN  REORGANIZATIONS  243 

money  to  assist  in  the  process  rightly  constitutes  a  claim  enforcible 
in  advance  of  all  the  old  claims  which  it  assisted  to  save. 

The  first  task  of  a  reorganization  committee  is  to  see  that  people 
having  various  classes  of  claims  upon  the  property  shall  be  satisfied 
in  proportion  to  the  value  of  their  claims.  When  many  classes  of 
obHgation  have  been  issued  it  is  a  matter  of  great  difficulty  to  deter- 
mine not  only  the  priority  of  each  claim,  but  also  the  probability 
of  payment  in  each  case  if  reorganization  should  not  occur. 

In  the  Atchison  case  of  1895  the  task  of  the  trustees  was  much 
simpler  than  it  otherwise  would  have  been  because  the  reorganiza- 
tion of  1889,  which  we  shall  consider  later,  had  consolidated  forty- 
three  forms  of  obligation  into  two.  The  funded  debt  in  1895  con- 
sisted of  but  four  main  types  of  bond.  Of  course  the  first  thing  to 
provide  in  a  reorganization  is  a  reduction  of  fixed  charges  so  that 
they  can  be  met  without  danger  of  default.  A  railroad,  unHke  most 
corporations,  cannot  well  go  into  insolvency,  pay  a  certain  percen- 
tage on  the  dollar,  and  then  shut  dovm.  It  is  a  going  concern,  and  so 
long  as  there  is  a  possibility  of  its  ever  doing  business  the  creditors 
had  rather  take  what  they  can  now  get  and  retain  a  claim  on  the 
possible  future  prosperity  than  to  take  a  fixed  percentage  now  and 
give  up  all  other  claims.  First,  then,  the  reorganization  committee 
must  show  what  is  the  maximum  that  the  road  can  surely  pay. 
Secondly,  they  must  determine  what  would  constitute  a  fair  claim 
upon  the  future  prosperity  of  the  company.  Thirdly,  they  must  see 
what  are  its  immediate  needs  in  the  way  of  cash  for  conducting 
business  economically,  for  presumably  if  it  needed  reorganization 
it  had  no  adequate  supply  of  cash  and  was  necessarily  somewhat 
run  down  in  an  effort  to  pull  through  its  trouble.  In  this  Atchison 
case,  then,  there  were  four  classes  of  obligations  to  be  treated  in  such 
a  way  that  each  should  make  enough  sacrifice,  and  not  too  much, 
in  regard  to  each  of  these  three  phases  of  reorganization,  —  that  is, 
reduction  of  fixed  charges,  claim  on  the  future  prosperity,  and  con- 
tribution for  immediate  cash  needs. 

The  first  class  of  obligations  were  various  small  lots,  as  equipment 
trust  bonds,  which,  since  they  were  a  first  claim  on  specific  property 
of  the  road,  were  very  clearly  worth  par.  Indeed,  if  they  were  not 
provided  for,  the  rolling  stock  which  secured  them  could  be  carried 
off.  No  one  could  deny,  therefore,  that  the  holders  of  this  class  of 


244  ACCOUNTS 

obligation  had  claims  upon  which  they  could  not  be  expected  to 
make  any  considerable  sacrifice.  They  were  given  in  return  for  their 
claims  an  issue  of  prior-lien  bonds,  in  the  main  bearing  the  old  rate 
of  interest  and  to  the  old  par  value.  These  involved  a  fixed  charge  on 
the  future  of  a  little  over  half  a  million  dollars. 

The  earnings  of  1894  under  the  receivership  had  been  about  six 
million  dollars,  and  it  was  thought  safe  to  pledge  the  road  to  pay 
about  four  and  a  half  million  in  fixed  interest  charges.  Since  the 
prior-lien  bonds  would  take  about  half  a  million,  four  million  would 
be  available  to  distribute  among  the  holders  of  the  other  obliga- 
tions. These  other  obligations  as  they  stood  involved  a  fixed  interest 
charge  of  nearly  $10,000,000,  and  consequently  must  be  cut  down 
more  than  one  half  in  such  fashion  that  each  must  sacrifice  in  accord- 
ance with  the  proportionate  value  of  the  security  upon  which  it  was 
based.  The  most  valuable  bonds  after  those  already  mentioned  were 
general  mortgage  bonds,  which  had  first  claim  upon  the  main  pro- 
perty of  the  road.  These  were  both  morally  and  legally  entitled  to  all 
the  earnings  up  to  $5,000,000  required  to  pay  the  4%  interest  on 
them;  but,  since  this  sum  could  not  be  earned  in  the  immediate 
future  and  yet  was  secured  by  mortgage,  these  bonds  were  a  danger 
to  the  stability  of  the  road,  —  for  when  interest  should  be  defaulted 
a  clique  of  bondholders  hostile  to  the  new  management  might  insti- 
tute foreclosure  proceedings.  It  was  better  for  the  bondholders  to 
accept  a  smaller  claim  for  interest  in  new  bonds  and  receive  in  com- 
pensation for  the  sacrifice  a  claim  on  the  future  earnings  of  the 
company  than  to  attempt  to  force  with  the  old  bonds  a  demand  that 
the  road  could  not  meet.  An  arrangement  was  therefore  made  that 
holders  of  the  general  mortgage  bonds  could  exchange  an  old  $1000 
bond  for  a  new  general  mortgage  bond  for  $750  and  receive  in  addi- 
tion $400  in  what  was  called  an  '*  adjustment  bond."  This  adjust- 
ment bond  was  for  the  first  five  years  of  its  life  to  be  a  claim  upon 
income  only,  at  the  rate  of  4%,  and  that  claim  was  to  be  non-cumula- 
tive; but  after  the  expiration  of  five  years,  the  claim  upon  income 
was  to  be  cumulative,  so  that  if  the  income  was  not  earned  in  one 
year  it  should  be  made  up  out  of  the  earnings  of  subsequent  years. 
The  total  life  of  the  bond  was  one  hundred  years.  The  proportion 
of  these  two  classes  of  bonds,  giving  a  total  of  $1150  for  $1000 
in  the  bonds  surrendered,  was  determined  on  an  interesting  basis. 


ACCOUNTING  IN   REORGANIZATIONS  245 

The  holders  of  the  old  general  mortgage  bonds  had  received  no 
interest  for  two  years  during  the  period  of  the  reorganization.  For 
this  they  were  entitled  to  $80.  The  new  adjustment  bonds  gave  a 
claim  to  interest  only  if  it  were  earned,  and  as  such  earning  was  not 
wholly  probable  the  holders  were  entitled  to  some  claim  upon  the 
future  in  compensation  for  the  sacrifice.  The  sacrifice  was  deemed 
to  be  equivalent  practically  to  $70.  Consequently,  of  the  $150  addi- 
tional par  value  of  new  bonds  given  in  exchange  for  old,  $80  was 
given  because  of  the  lost  interest  during  the  reorganization,  and  $70 
as  compensation  for  the  non-cumulative  element  in  the  adjustment 
bond. 

The  issue  of  new  general  mortgage  bonds  and  adjustment  bonds, 
with  the  prior-lien  bonds  already  mentioned,  would  consume  practi- 
cally all  the  assured  earnings  of  the  road  for  a  number  of  years. 
Holders  of  the  original  second- mortgage  bonds,  therefore,  must 
postpone  all  their  claims  until  the  somewhat  distant  future.  It  was 
right  that  this  should  be  so,  for  these  bonds  were  subordinate  to  the 
others.  If  the  mortgage  had  been  foreclosed,  moreover,  these  bonds 
would  have  proved  practically  worthless,  for  the  road  was  incapable 
at  that  time  of  earning  more  than  enough  to  pay  interest  upon  the 
first  two  classes  mentioned.  The  holders  of  these  second- mortgage 
bonds,  then,  recognizing,  as  they  must,  the  poor  value  of  their  pro- 
perty, could  not  well  object  to  a  demand  that  they  make  a  considerable 
sacrifice.  They  were  asked  to  contribute  some  ready  cash  for  the 
reorganization  of  the  property.  They  could  see  that  their  bonds  were 
worth  at  present  practically  nothing ;  and  they  could  see  that  a  liberal 
contribution  in  cash  ought  to  put  the  road  on  a  good  paying  basis 
for  the  future,  so  that  their  property  would  become  valuable.  They 
contributed  in  cash  4%  of  the  amount  of  their  bonds,  and  re- 
ceived 5  %  non-cumulative  preferred  stock  to  the  amount  of  the  par 
value  of  the  bonds  which  they  surrendered.  This  exchange  of  bonds 
for  stock  of  course  surrendered  their  right  to  seize,  on  a  mortgage, 
the  property  of  the  corporation ;  but  since  an  attempt  to  enforce  the 
old  mortgage  claim  would  have  resulted  simply  in  getting  payment 
for  the  holders  of  first-mortgage  bonds  without  benefit  to  themselves, 
the  right  which  they  surrendered  was  practically  worthless,  and  pre- 
ferred stock  was  as  good  as  anything  they  could  fairly  ask  for.  The 
holders  of  these  second-mortgage  bonds  could  hardly  believe  that  if 


246  ACCOUNTS 

they  paid  off  the  first- mortgage  bonds  and  attempted  to  run  the  road 
themselves  they  should  make  more  than  under  the  present  arrange- 
ment; and  in  that  case  they  would  be  forced  to  advance  a  large 
amount  of  money.  Since  their  second- mortgage  bonds  had  borne 
but  4%  and  their  preferred  stock  v^as  to  bear  5%,  the  arrangement 
was  a  fair  one,  for  if  the  road  should  become  prosperous  their  new 
5%  preferred  stock  would  be  better  than  the  old  4%  bonds.  These 
old  second- mortgage  bonds  had  been  of  two  classes.  Class  A  had 
given  a  claim  to  interest  at  an  increasing  rate  until  it  reached  a 
maximum  of  4%  in  five  years;  and  Class  B  was  to  bear  interest 
regularly  at  4%.  Class  A  was  accordingly  exchanged  at  the  rate  of 
113%  of  its  face  in  preferred  stock,  and  Class  B  at  118%. 

The  old  stock  was  converted  into  new  common  stock,  and  stock- 
holders were  assessed  $10  per  share  to  help  rehabihtate  the  road. 
For  this  $10  assessment  they  received  new  preferred  stock.  This,  of 
course,  was  a  just  treatment  of  the  holders  of  old  common  stock,  for 
the  stock  gives  no  claim  until  all  other  obligations  are  satisfied,  and 
it  was  these  men  who  were  under  the  greatest  obHgation  to  furnish  the 
road  cash  for  putting  it  upon  its  feet  once  more. 

It  is  interesting  in  this  connection  to  note  the  bookkeeping  effect 
of  these  transactions.  The  preferred  stock  was  increased  $22,500,000 
over  the  corresponding  bonds,  and  the  new  bonds  were  increased 
$19,500,000  over  the  corresponding  old  bonds.  The  result  was  an 
increase  among  the  liabilities  of  $42,000,000,  offset  by  an  increase 
of  cash  assets  of  about  $13,000,000.  Some  other  assets,  however, 
were  found,  as  we  have  seen,  to  be  highly  overvalued,  and  were  writ- 
ten off.  It  was  inevitable,  therefore,  that  the  flexible  assets  should 
be  written  up  in  some  fashion,  so  that  the  increase  of  liabilities 
should  be  properly  offset.  Cost  of  Road  was  actually  increased  nearly 
$40,000,000,  and  this  was  clearly  due  to  the  increase  in  capitaliza- 
tion, —  not  arising  from  earning  capacity,  but  demanded  by  mere 
bookkeeping  convenience.  In  one  sense  this  was  correct,  for  if  the 
par  value  of  bonds  outstanding  could  be  increased  arbitrarily  and  a 
part  of  the  ultimate  security  for  those  bonds  was  the  cost-of-road 
account,  the  cost-of-road  account  must  be  written  up  to  corre- 
spond with  the  increase  of  bond  issue.  To  be  sure,  the  situation  was 
somewhat  forced,  and  no  one  could  say  that  the  road  itself  was 
voluntarily  accepted  as  security  for  so  large  an  issue  of  bonds,  but  the 


ACCOUNTING  IN   REORGANIZATIONS  247 

fact  remains  that  the  relationship  did  exist.  On  the  balance  sheet 
the  peculiarity  of  the  situation  was  partly  covered  by  the  elasticity 
of  the  title  of  the  account,  "  Cost  of  Road  and  Franchises."  This 
furnishes  a  very  good  illustration  of  the  fact  that  a  cost-of-road 
account  does  not  necessarily  represent  either  the  actual  cost  or  the 
capitalization  of  the  earning  capacity. 

The  previous  Atchison  reorganization,  in  1889,  which  much 
simpHfied  matters  for  the  reorganization  of  1895,  is  interesting  for 
the  great  variety  of  obligations  consolidated.  Nine  of  the  forty-three 
kinds  were  issued  by  the  Atchison  proper,  some  were  general  mort- 
gages upon  subsidiary  lines,  some  w^re  mortgages  upon  specific 
pieces  of  property  or  branch  lines,  and  some  were  income  bonds. 
The  general  condition  was  therefore  extremely  complicated.  This 
reorganization  of  1889  was  conducted  without  putting  the  road  into 
the  hands  of  a  receiver  and  was  undertaken  to  reduce  the  fixed 
charges  before  a  default  in  interest  should  become  necessary.  The 
task  was  to  determine  the  real  proportionate  value  of  these  forty- 
three  kinds  of  obligation.  The  fixed  charges  before  this  reorganiza- 
tion had  been  over  $11,000,000,  and  it  was  necessary  to  reduce  them 
to  about  $7,000,000.  Since  the  reorganization  was  voluntary,  it  was 
not  possible  to  reduce  the  maximum  rate  of  return  for  any  class  of 
obligation;  but  each  was  to  be  offered  such  an  apportionment  of 
practically  certain  return  that  the  success  of  the  reorganization  plan 
would  be  assured.  The  allowance  for  difference  in  value  between 
the  different  classes  of  old  bonds  was  accomplished  by  the  appor- 
tionment of  differing  ratios  of  mortgage  bonds  and  income  bonds 
to  each.  For  example,  the  bonds  supposed  to  be  the  best  of  the 
forty-three  kinds,  those  having  the  greatest  security,  were  certain 
7%  bonds.  For  a  $1000  bond  of  these  were  given  $1100  in  new 
mortgage  4's  and  $520  in  income  5's.  The  principle  was  this:  the 
new  4%  mortgage  bonds  would  give  $44  in  interest,  and  the  5% 
income  bonds,  if  the  interest  should  be  earned,  would  give  $26,  a 
total  of  $70,  which  was  7%  upon  the  original  $1000  bonds  sur- 
rendered ;  two  thirds  of  this  amount  was  practically  certain,  being 
based  upon  expected  earnings,  and  the  other  third  gave  practically 
as  good  probability  of  interest  as  the  old  bonds,  which  the  road 
already  found  difficulty  in  meeting ;  the  extra  principal,  or  $620,  was 
a  bonus,  but  not  too  much,  for  both  bonds  were  to  run  one  hundred 


248  ACCOUNTS 

years.  One  of  the  poorest  of  the  forty-three  kinds,  a  second- mort- 
gage 6%  bond  on  an  auxiliary  road,  was  exchanged  for  $300  in  new 
mortgage  4's  and  $960  in  income  5's.  The  $300  at  4%  would  yield 
$12,  and  $960  at  5%  would  yield  $48,  a  total  of  $60.  Here,  one 
fourth  was  in  practically  certain  mortgage  bonds  and  the  remaining 
three  fourths  was  in  the  very  doubtful  income  bonds,  which  might 
yield  nothing  for  years.  Yet  even  in  this  case  the  probabiUty  of 
income  was  practically  as  good  under  the  reorganization  as  under 
the  former  plan. 

Thus  the  risks  were  apportioned  among  the  forty-three  classes 
so  as  to  give  each  a  fair  exchange  for  its  estimated  value  and  se- 
curity ;  and  the  new  bonds  were  of  a  sort  to  simplify  very  much  the 
administration  of  the  finances  of  the  company.  In  1892  the  income 
bonds  were  converted  into  second-mortgage  bonds,  and  additional 
second-mortgage  bonds  were  issued  for  cash  to  enable  the  road  to 
make  extensive  improvements.  As  we  have  seen  in  our  study  of  the 
history  from  1891  to  1893,  however,  the  interest  on  these  could  not 
be  met,  and  in  1893  even  the  mortgage  4's  became  doubtful,  so  that 
the  other  reorganization  of  1895  was  necessary  to  cut  down  once 
more  the  fixed  interest  charges  to  $4,500,000. 

These  two  cases  of  reorganization  suggest,  of  course,  but  a  few 
of  the  many  devices;  but  they  indicate  the  general  principles  and 
show  sufficiently  how  accounts  are  called  into  use  and  how  they 
are  affected  by  changes  of  this  sort.  Unless  based  on  adequate 
knowledge  of  actual  and  probable  income,  reorganization  schemes 
are  doomed  to  failure.  The  Atchison  reorganization  of  1889  was 
based  on  an  estimate  of  income  that  was  never  realized ;  and  within 
four  years  a  new  plan  became  imperative. 


^1 


CHAPTER  SIXTEEN 

SOME    GENERAL    PRINCIPLES   ILLUSTRATED    IN    BANK 
ACCOUNTING 

In  some  respects  bank  accounting  is  peculiarly  simple,  for  every- 
thing handled  has  a  definite  stated  value  in  dollars  and  cents.  In 
most  respects  it  is  useless  to  try  to  keep  track  upon  the  books  of 
the  specific  article  traded  in,  for  identification  of  bills  and  coin  is 
unnecessary.  Of  notes,  drafts,  bonds,  stocks,  etc.,  however,  it  is 
always  desirable  to  keep  a  complete  record.  The  bookkeeping  with 
regard  to  notes  and  drafts  is  explained  in  Appendix  A,  II ;  and 
the  record  of  stocks  and  bonds  may  be  best  show^n  in  connection 
with  trust  accounting.  For  the  ordinary  transactions  of  banking, 
the  chief  accounting  peculiarity,  aside  from  the  mere  mechanical 
details  of  keeping  the  books,  is  the  form  of  the  balance  sheet,  which 
depends  upon  several  things  of  a  technical  nature. 

For  instance,  the  national  banking  law  requires  that  each  bank 
shall  conform  to  certain  regulations  for  its  membership  in  the  na- 
tional banking  system,  shall  maintain  security  for  its  bank  notes 
issued,  and  shall  keep  a  specified  reserve  for  deposits.  The  pub- 
lished balance  sheet  should  give  the  necessary  information  con- 
cerning the  fulfillment  of  these  requirements.^ 

On  the  debit  side  of  a  bank  balance  sheet  the  first  item  is  usually 
Loans,  or  Bills  Discounted.  These  are  often  divided  into  several 
classes,  according  to  the  sort  of  transaction,  —  for  instance,  com- 
mercial paper,  time  loans  on  collateral,  etc.  The  second  item,  or 
group  of  items,  is  usually  United  States  Bonds.  Since  all  national 
banks  must  hold  a  certain  amount  of  such  bonds,  the  amount  vary- 
ing with  the  amount  of  capital  stock,  this  item  must  be  stated  by 
itself.  If  bank  notes  are  issued  they  must  be  secured  by  government 
bonds  on  deposit  at  Washington,  and  hence  the  amount  of  such 
bonds  must  be  stated  by  itself  for  comparison  with  the  notes  out- 
standing. If  the  bank  is  a  depositary  of  government  funds,  it  must 
have  on  deposit  in  Washington  government  bonds  for  security ;  and 
therefore  these  bonds  must  be  stated  by  themselves  for  comparison 
*  See  note,  regarding  recent  changes,  at  the  end  of  this  chapter,  page  254. 


250  ACCOUNTS 

with  the  government  deposits  with  the  bank.  So  all  national  banks 
must  have  one  lot  of  government  bonds,  and  may  have  two  or  three. 
The  next  item  is  stocks,  etc.,  which  must  be  stated  because  na- 
tional banks  are  not  expected  to  hold  stocks  except  as  they  may 
come  into  possession  through  the  confiscation  of  collateral  or  ac- 
ceptance to  secure  themselves  against  loss  in  case  of  debt.  The  next 
item  is  sums  due  from  reserve  agents.  This  is  of  great  importance, 
because  the  national  banking  law  provides  that  of  the  reserve  re- 
quired to  be  maintained  by  each  bank  a  certain  proportion  may 
be  kept  on  deposit  with  other  designated  banks  in  what  are  called 
reserve  cities.  In  the  case  of  banks  not  in  reserve  cities  three  fifths 
of  the  total  required  for  reserve  may  be  kept  in  such  reserve-city 
banks;  and  for  banks  in  reserve  cities  one  half  of  the  required  re- 
serve may  be  kept  on  deposit  with  banks  in  what  are  called  central 
reserve  cities,  —  New  York,  Chicago,  and  St.  Louis.  The  next  item 
is  usually  sums  due  from  other  banks,  that  is,  banks  not  designated 
as  reserve  agents.  The  significance  of  separating  these  items  will 
appear  later,  with  the  reason  for  stating  separately  the  next  two 
items,  clearing  house  items  and  checks,  and  national  bank  notes 
held  as  cash.  Next  appears  the  item  of  lawful  money,  which  includes 
only  those  sorts  of  money  which  may  be  counted  as  reserve  for 
deposits  —  and  national  bank  notes  are  not  among  them.  The  last 
item  of  importance  on  the  assets  side  of  the  balance  sheet  is  the 
redemption  fund  with  the  United  States  treasurer,  a  fund  required 
by  law  to  be  constantly  on  deposit  in  Washington,  if  notes  are 
issued,  to  enable  the  treasurer  at  all  times  to  redeem  such  notes. 
The  amount  of  this  fund  is  5%  of  the  amount  of  notes  outstanding 
from  any  bank. 

Upon  the  credit  side  of  the  balance  sheet  the  first  item  is  of  course 
Capital  Stock,  which  is  required  by  law  to  be  of  a  certain  minimum. 
The  next  item  is  Surplus,  and  this  must  be  distinguished  because 
national  banks  are  required  to  set  aside  of  their  profits  a  certain 
proportion  until  a  reserve  shall  have  been  accumulated  of  20%  of 
their  capital  stock.  The  next  item  is  Undivided  Profits,  which 
theoretically  is  simply  small  sums  which  the  bank  has  deemed  hardly 
worth  while  to  distribute  to  stockholders,  though  commonly  this 
is  allowed  to  accumulate,  furnishing  a  second  surplus.  Next  ap- 
pears the  amount  of  national  bank  notes  issued  and  outstanding. 


PRINCIPLES    ILLUSTRATED    IN    BANK  ACCOUNTING    2$  I 

This,  very  clearly,  must  bear  relation  to  the  amount  both  of  govern- 
ment bonds  and  of  the  redemption  fund  on  deposit  with  the  trea- 
surer at  Washington  to  secure  that  circulation.  Next  is  the  amount 
due  to  other  banks,  to  be  considered  later.  Finally  comes  Deposits, 
for  which  the  required  reserve,  25%  in  reserve  cities  and  15%  in 
other  places,  must  be  constantly  maintained. 

It  would  appear  to  be  a  simple  matter  to  determine  the  require- 
ment of  reserve  by  applying  the  proper  percentage  to  the  figure  of 
deposits  given  upon  the  balance  sheet.  When  the  national  banking 
law  requiring  this  percentage  of  reserve  came  to  be  applied,  how- 
ever, the  Comptroller  of  the  Currency  found  many  complications. 
He  was  asked,  for  instance,  whether,  since  national  bank  notes  are 
not  included  in  lawful  money,  a  bank  holding  many  such  notes  of 
other  banks  would  be  required  to  maintain  just  as  much  reserve 
in  lawful  money  as  another  bank  which  had  only  a  small  number 
of  such  notes.  The  national  bank  notes  are  secured  at  Washington, 
and  it  seems  hardly  fair  that  they  should  not  be  counted  at  all  in 
determining  the  reserve  for  deposits.  The  Comptroller  ruled  that 
though  national  bank  notes  could  not  be  included  v/ith  lawful  money 
to  offset  deposits  on  the  basis  of  four  for  one  (25%  reserve),  or  six 
and  two  thirds  for  one  (15%  reserve),  as  lawful  money  could  be 
counted,  they  might  be  allowed  to  count  on  the  basis  of  one  for  one ; 
that  is  to  say,  the  amount  of  national  bank  notes  held  might  be 
subtracted  from  the  deposits  before  the  requirement  for  reserve 
should  be  figured.  So  one  dollar  in  bank  notes  will  reduce  by  one 
dollar  the  amount  of  deposits  required  to  be  covered.  Since  the 
Redemption  Fund  for  redeeming  bank  notes  is  in  lawful  money, 
it  may  be  counted,  while  unimpaired,  on  a  basis  of  four  for  one  or 
six  and  two  thirds  for  one  as  reserve  for  deposits. 

The  Comptroller  was  also  asked  whether,  since  the  sums  due  to 
other  banks  (which  of  course  are  deposits)  must  be  included  in  the 
deposits  for  which  a  bank  must  maintain  a  reserve,  sums  due  from 
other  banks  might  not  be  counted  to  offset  such  deposits.  He  ruled 
that  sums  due  from  other  banks  might  be  counted  to  offset  sums 
due  to  other  banks;  but  if  there  were  any  excess  of  sums  due  from 
other  banks  over  the  sums  due  to  other  banks,  such  excess  should 
not  be  counted  to  offset  other  deposits.  This  allowance  sometimes 
raises  a  problem  that  only  a  complicated  mathematical  process  will 


252  ACCOUNTS 

solve.  This  problem  is  interesting  to  note.  Up  to  a  certain  limit  a 
bank  may  count  its  own  deposits  with  reserve  agents,  as  already 
indicated,  on  a  basis  of  four  for  one  or  six  and  two  thirds  for  one, 
to  cover  deposits  made  by  others  with  it.  Sometimes  it  has  on  de- 
posit with  reserve  agents  a  sum  so  large  that  not  all  of  it  can  be 
counted  to  cover  its  own  liability  for  deposits  (as  already  indicated, 
only  one  half  of  the  reserve  of  reserve-city  banks  may  be  kept  on 
deposit  with  reserve  agents,  and  only  three  fifths  of  the  reserve  of 
other  banks  may  be  so  kept).  In  part  we  determine  the  amount  of 
deposits  requiring  reserve  by  subtracting  from  sums  due  to  other 
banks  the  sums  due  from  banks  not  reserve  agents.  The  balance  is 
a  part  of  the  deposits  requiring  reserve,  and  this  determines  how 
much  may  be  counted  of  the  sums  due  from  reserve  agents.  Sums 
due  from  reserve  agents  in  excess  of  this  may  be  counted  to  reduce, 
further,  not  four  for  one  or  six  and  two  thirds  for  one  but  one  for  one, 
the  sums  due  to  other  banks  and  requiring  reserve.  This  last  re- 
duction itself  reduces  the  amount  which  may  be  counted  as  reserve 
with  reserve  agents;  and  this  new  reduction  increases  the  excess 
with  reserve  agents,  and  reduces  the  liabiHty  for  sums  due  other 
banks,  —  which  in  turn  reduces  the  amount  counted  with  reserve 
agents,  increases  the  excess,  and  so  on,  ad  infinitum.  The  escape 
from  this  interminable  process  is,  of  course,  a  mathematical  formula 
of  an  algebraic  type,  which  is  not  necessary  to  examine  here.  One 
method  of  treating  the  problem  is  illustrated  in  Appendix  F,  page 

431. 

Similarly,  the  Comptroller  ruled  that,  since  clearing-house  items 
(checks  and  other  items  ready  to  be  presented  against  other  banks) 
are  of  the  same  nature  as  sums  due  from  other  banks,  they  might 
be  counted  on  the  basis  of  one  for  one  against  deposits  and  might 
be  subtracted  from  the  amount  of  deposits  before  the  requirement 
for  reserve  should  be  figured. 

It  is  now  evident  why  a  bank  balance  sheet  distinguishes  many 
items  which  are  apparently  of  a  like  sort,  as  bank  notes  from  legal 
tender. 

The  form  used  makes  it  possible  to  know  practically  all  that  need 
be  known  except  the  one  most  important  thing,  which  nothing  but 
the  books  themselves  or  the  original  documents  could  possibly  tell. 
The  most  striking  characteristic  of  bank  accounting  as  distinguished 


PRINCIPLES    ILLUSTRATED    IN    BANK  ACCOUNTING    253 

from  other  types  is  the  fact  that  two  banks  with  identical  balance 
sheets  may  be  utterly  dissimilar  in  solvency.  The  most  important 
item  among  the  assets  of  a  bank  is  its  loans,  and  of  the  value  of  these 
nobody  is  able  to  form  any  judgment  unless  he  knows  the  details 
of  them  and  knows,  better  than  almost  any  one  can  know,  the 
character  of  the  men  who  take  responsibility  for  them.  Upon  prac- 
tically every  other  sort  of  commercial  property  it  is  possible  to  make 
some  sort  of  estimate  of  value;  but  when  a  bank  happens  to  have 
many  eggs  in  one  basket  a  few  commercial  failures,  perhaps  all  con- 
sequent on  one  mischance,  may  cause  it  to  go  under  in  spite  of  a  very 
fine  showing  on  its  balance  sheet.  This  has  been  illustrated  many 
times.  Only  one  who  can  see  the  details  of  the  loans  can  form  an 
adequate  judgment  of  the  real  solvency  of  the  bank.  Many  dis- 
closures of  the  last  few  years  have  indicated  that  with  alarming 
frequency  directors  turn  over  to  subordinate  officers  what  they  should 
recognize  as  their  own  responsibility;  and  practically  all  the  bank 
failures  which  have  excited  general  comment  could  have  been  avoided 
and  would  have  been  avoided  if  any  one  with  proper  responsibility 
had  examined  the  loans  and  the  adequacy  of  the  security  for  them. 
More  often  in  banking  than  elsewhere  has  embezzlement  proved 
possible ;  yet  this  should  not  be  the  case.  There  is  but  little  more 
reason  why  embezzlement  should  be  common  in  banking  than  in  any 
other  lines  of  business.  The  explanation  here,  as  in  the  matter  of 
loans,  is  that  not  sufficient  responsibility  has  been  taken  by  those  in 
charge.  The  ways  by  which  theft  may  be  temporarily  covered  are 
numerous,  but  none  of  them  will  escape  proper  examination ;  and  by 
proper  examination  is  meant  not  such  examination  as  can  be  given 
by  bank  examiners  —  for  their  work  is  necessarily  hasty  and  some- 
what superficial,  —  but  only  such  as  most  banks  can  provide  for 
themselves.  In  most  large  banks  the  number  of  clerks  in  each  group 
is  so  large  that  the  duties  can  be  often  changed.  Wherever  it  is  known 
that  any  day  the  clerk  who  has  been  accustomed  to  work  at  a  certain 
desk  is  likely  to  be  shifted  to  another  and  a  new  man  is  likely  to  take 
his  place,  no  one  dares  to  leave  his  w^ork  at  night  with  a  bookkeeping 
lie  behind  him.  This  method  of  constantly  changing  duties  is  com- 
ing to  be  more  and  more  widely  adopted  and  is  proving  efficacious. 
Every  man  on  taking  a  new  task  is  held  responsible  for  the  correct- 
ness of  his  balance ;  and  every  man  is,  therefore,  bound  to  see  that 


2S4  ACCOUNTS 

the  accounts  of  his  predecessor  are  correct  before  he  is  willing  to 
perform  any  new  transactions.  Unless  dishonesty  affects  the  whole 
group,  the  system  furnishes  its  own  check.  When  the  changes  are 
made  frequently  and  impersonally  throughout  a  bank,  no  man  can 
feel  offended  at  finding  his  duties  changed ;  the  change  is  no  viola- 
tion of  tact  or  implication  of  blame  to  any  one.  In  practically  every 
case  of  conspicuous  embezzlement  for  many  years  it  has  been  no- 
ticeable that  the  thief  has  been  unwilling  to  take  a  vacation.  For 
instance,  the  commonest  method  of  embezzlement  is  to  tamper  with 
inactive  accounts  of  depositors.  A  clerk  who  knows  that  certain 
accounts  are  unHkely  to  change  often  may  make  on  his  books  many 
changes  in  such  accounts  with  practical  certainty  that  the  discrep- 
ancy will  not  be  detected  if  only  he  can  transfer  those  discrepancies 
in  due  time  to  other  accounts  which  have  become  inactive  while  the 
first  accounts  were  becoming  active.  In  a  case  discovered  a  few  years 
ago  a  clerk  had  been  carrying  on  this  sort  of  process  for  many  years, 
trusting  entirely  to  his  memory  as  to  the  names  and  amounts  of 
changes  —  but  of  course  he  never  dared  to  take  a  vacation.  In 
another  case  a  bank  clerk  in  charge  of  the  incoming  mail  had  taken 
regularly  from  each  day's  mail  enough  checks  and  drafts  which  had 
not  yet  been  recorded  to  cover  his  discrepancy  of  the  day  before. 
That  is  to  say,  he  had  always  at  his  disposal  a  large  body  of  unre- 
corded checks  and  drafts  whose  existence  he  only  of  all  the  people 
in  that  bank  knew  anything  about ;  and  it  was  a  very  simple  matter 
for  him  to  make  his  accounts  balance  by  using  some  of  those  unre- 
corded items  to  settle  the  accounts  of  the  day  before.  He,  too,  never 
dared  to  take  a  vacation ;  but  when,  on  account  of  sickness,  one  was 
forced  upon  him,  the  discrepancy  was  instantly  discovered. 

Note.— At  the  time  of  going  to  press  with  this  revised  edition,  the 
Federal  Reserve  system  is  under  inauguration.  The  new  law  makes  a 
few  changes  in  requirements,  but  none  of  these  affects  the  accounting 
principles  involved.  The  purpose  of  this  chapter  is  primarily  to  illus- 
trate accounting  principles  rather  than  to  discuss  banking  practice,  and 
some  phases  of  the  old  law,  as  interpreted  in  fact,  are  more  valuable  as 
illustrations  than  any  corresponding  phases  of  the  new  law  are  likely  to 
be.  In  everything  except  non-essential  administrative  details,  this  chap- 
ter holds  true  for  the  new  law  as  well  as  for  the  old. 


CHAPTER  SEVENTEEN 

SOME  GENERAL   PRINCIPLES   ILLUSTRATED    IN   TRUST 
ACCOUNTING 

A  TRUST  may  owe  its  origin  to  any  one  or  more  of  several  things.  A 
trust  company  as  well  as  an  individual  may  be  the  administrator  or 
the  executor  of  an  estate;  it  may  hold  property  as  guardian  for  a 
minor  or  an  incompetent  person ;  it  may  manage  property  for  per- 
sons in  ill  health  or  abroad ;  it  may  take  charge  of  marriage  settle- 
ments ;  it  may  serve  as  assignee  or  receiver  in  bankruptcy  proceed- 
ings; and  it  may  serve  many  other  similar  functions.  The  chief 
peculiarity  of  trust  accounting  is  that  the  books  must  show  not 
merely  how  much  property  and  income  are  to  be  accounted  for  in 
each  trust,  but  what  particular  property  belongs  to  it;  for  even 
though  a  trust  fund  is  earning  but  little  and  the  average  earnings  of 
investments  held  by  the  company  are  high,  the  beneficiary  of  the 
trust  has  no  claim  to  the  earnings  of  other  trusts. 

Each  trust  involves  usually  three  elements,  —  principal  sum,  in- 
vested sum,  and  uninvested  sum ;  and  the  amount  of  any  one  of  these 
is  Hkely  to  be  at  any  time  changed  by  income  or  loss.  A  trust  ledger, 
therefore,  must  be  so  arranged  that  a  page  or  a  portion  of  a  page 
allotted  to  each  account  shall  show  at  a  glance  these  three  elements. 
A  convenient  arrangement  for  such  a  ledger  is  to  have  three  separate 
groups  of  columns,  one  each  for  principal,  income,  and  investment ; 
the  difference  between  the  investment  and  the  principal  is  the  unin- 
vested part.  To  make  the  record  complete,  a  column  for  the  debit 
and  one  for  the  credit  is  usually  provided  for  each  group,  and  for  the 
sake  of  making  immediate  reference  possible  a  balance  column  is 
also  desirable  for  each.   Such  a  ledger  would  look  as  follows : 


2s6 


ACCOUNTS 


I 


-5i 


1 

I 


a 


1 

1                s  1 

J2 

2.    8 

is 

i 

a 

5 

8               e, 

8 

a 

n 

8              a 

!>.                                                          to 

i        1 

11                                     11 

15 
Q 

^ 

u 

.■a 

1 
u 

1 

8               S, 

8                S. 

o£ 

8               8 
8               g 

M                                            M 

1 

8    8    ^ 

O         O         t^ 

^  ^  ^ 

*J 

8    8          g> 
^8          ^ 

•So 
> 

NO                                   VO 
•1                                           M 

Item 

Accession 

Interest 

Amortis. 

Repairs 

Rent 

Transfer 

Sale 

1/3      G 


CO  _, 


>-2 

>^  o 

o3    d 


C5  £    5:?    r! 

o  H  a.S 

^   (J  <J  ^  ^ 

^  o  Ji 

)i.  2  ^"^       ^ 

§  ^  >  ^  S 

s  ^  ^  i  « 

g    >    o    c^    rt 

^  s  §  ^  ^ 

3  :2  G  ^ 

o  '2   p3   p   ^ 

O    ^    >-    ^    C5 
2      ^-5  'T3    bO 

c!  ii  *^  c;  (« 

M  ^    C    c^    CI, 
^  ^    o     ^  - 

•=1  s  ^  <=> 

H  ^  (u   aj   g 
cd    (U    0)    60 


PRINCIPLES    ILLUSTRATED   IN    TRUST   ACCOUNTING      257 

The  trust  ledger  is,  of  course,  a  subordinate  book,  for  an  account 
is  provided  in  the  general  ledger  to  cover  the  total  of  all  trusts. 
When  a  trust  is  opened,  the  account  in  the  trust  ledger  is  credited, 
in  the  column  provided  for  principal  credit,  with  the  principal  sum, 
and,  if  the  principal  is  all  invested,  the  same  amount  is  extended  into 
the  debit  investment  column.  In  this  case  the  debits  and  credits  are 
equal ;  for  the  trust  company  is  responsible  for  the  property  as  agent, 
and  it  registers  on  its  books  both  the  liability  for  the  property  and 
the  asset  with  which  to  meet  that  liability.  If  any  part  of  the  prin- 
cipal is  in  cash,  it  is  not  necessary  to  enter  the  fact,  for  the  difference 
between  the  two  columns — that  is,  principal  credit  and  investment 
debit  —  shows  the  trust  company's  liabiHty  for  uninvested  sums. 
When  income  is  received,  income  is  credited  in  the  gross  credit  col- 
umn, the  commission  is  deducted,  and  the  net  amount  is  extended 
into  the  net  credit  column.  When  payments  on  account  of  income 
are  m_ade,  such  as  taxes,  repairs,  insurance,  or  distribution  to  per- 
sons authorized  to  receive  income,  the  amount  is  debited  in  the  debit 
income  column.  Balance  of  income  intended  not  for  distribution 
but  for  increment  of  principal  may  be  transferred  to  the  column  for 
principal  credits  at  any  time,  and  until  invested  it  shows  as  a  cash 
liability  of  the  trust  company.  Similarly,  principal  distributed  is 
entered  in  the  principal  debit  column,  and  investment  sold  is  entered 
in  the  investment  credit  column. 

Many  subordinate  books  are  necessary  for  handling  the  details  of 
trusts.  A  mere  mention  of  a  few  for  illustration  will  serve  our  pur- 
pose here.  In  the  first  place,  a  record  must  be  kept  of  the  details 
of  the  terms  of  each  trust,  —  that  is,  the  terms  of  a  will  or  deed 
or  mortgage  or  assignment  creating  the  trust,  sometimes  including 
special  instructions  as  to  how  the  trust  funds  may  be  invested,  and 
usually  including  provisions  as  to  the  distribution  or  the  accumula- 
tion of  the  fund.  This  is,  of  course,  a  legal  matter  of  great  impor- 
tance. Of  course,  too,  a  schedule  of  the  specific  property  belonging 
to  each  trust  must  be  correctly  entered,  designating  the  particular 
stocks,  bonds,  mortgages,  loans,  real  estate,  etc.,  even  mentioning 
them  by  number  when  any  number  is  attached.  The  necessity  for 
this  may  not  at  first  seem  obvious;  but  in  case  a  trust  company  holds 
numerous  bonds  of  the  same  class  belonging  to  different  trusts  and 
some  of  them,  in  accordance  with  the  terms  of  the  issue  of  the  bonds, 


258  ACCOUNTS 

are  called  in  for  redemption,  the  trust  company  must  know  to  which 
trust  belong  those  called  in,  for  the  call  may  mean  the  need  of  rein- 
vestment at  a  lower  rate  in  some  other  security.  Each  trust  must 
suffer  its  own  losses  and  receive  its  own  gains.  Sometimes  blanket 
trusts  are  created,  each  beneficiary  of  which  is  to  share  proportion- 
ately; but  each  trust  of  that  sort  is  a  unit,  however  numerous  the 
beneficiaries  may  be. 

If  the  trusts  are  many  it  is  desirable  to  keep  also  a  list  of  securities 
arranged  not  by  trusts  but  by  titles,  so  that  at  any  time  the  company's 
holdings  of  any  particular  security  may  be  easily  learned  from  the 
books.  Many  trusts  are  held  under  such  terms  that  it  becomes  the 
company's  duty  to  change  the  investment  under  changing  conditions, 
and  unless  a  careful  index  is  kept  of  the  different  investments  suffi- 
cient watchfulness  cannot  be  exercised. 

If  loans  are  made  on  collateral,  the  property  held  as  collateral 
must  be  indexed  on  still  other  bases.  An  index  must  be  kept  of  the 
collateral  for  each  loan,  so  that  one  may  learn  at  a  glance  whether 
on  a  down  ward  market  the  security  is  ample  for  the  loan ;  an  index 
must  be  kept  for  each  kind  of  security  held  as  collateral,  so  that  when 
a  stock  or  bond  becomes  questionable  instant  reference  will  show 
upon  whom  to  call  for  more  collateral;  and  another  index  must 
be  arranged  on  the  basis  of  borrowers'  names  so  that  one  may  learn 
at  any  time  the  total  amount  of  all  loans  to  any  individual. 

The  details  of  investments  are  recorded  in  subordinate  ledgers. 
In  a  large  concern  there  would  be  separate  ledgers  for  bonds  and 
for  mortgages,  but  the  principle  is  the  same  for  both  except  that  the 
latter  must  usually  provide  for  partial  payments.  A  bond  ledger  is 
arranged  usually  with  space  for  recording  not  only  purchases  and 
sales,  that  is,  ordinary  debit  and  credit  to  the  account,  but  also  for 
interest  payments  and  for  amortisation  figures,  for  each  separate 
holding.  Interest  payments  must  be  recorded  so  that  defaulted  in- 
terest may  be  shown.  Good  bookkeeping  requires  that  on  such  a 
ledger  interest  shall  be  debited  whenever  due  and  credited  whenever 
paid.  The  amount  due  and  unpaid  is  then  always  distinctly  shown 
as  a  balance.  An  investment  corporation  will  usually  divide  its 
interest  account,  as  already  indicated  in  Chapter  XII,  into  three 
accounts,  —  Interest  Accrued,  Interest  Earned,  and  Interest  Due. 
Only  the  last  of  these  need  appear  on  the  bond  ledger,  of  course; 


I 


PRINCIPLES   ILLUSTRATED    IN    TRUST  ACCOUNTING     259 

the  others  are  figured  periodically  and  are  entered  on  the  principal 
books  only.  Usually,  for  convenience,  columns  are  provided  in  the 
bond  ledger  to  preserve  the  cost  value  and  the  market  value,  —  not, 
of  course,  to  be  included  in  the  balance-sheet  figures,  but  for  general 
information. 

In  the  treatment  of  sales  of  bonds  care  must  be  taken  that  the 
book  value  be  not  thrown  out  of  accord  with  the  facts.  If,  for  in- 
stance, when  the  book  value  of  $100,000  worth  of  bonds  is  at  $100,- 
290,  one  half  of  those  bonds  is  sold  for  $51,145  (a  profit  of  $1000) 
and  the  bond  account  is  then  credited  for  the  amount  of  sales,  the 
balance  will  show  on  the  books  $49,145,  which  would  mean,  if  it 
means  anything,  that  the  value  of  the  bonds  remaining  on  hand  is 
at  that  figure;  yet  we  know  from  our  amortisation  table  that  the 
value  of  those  bonds  is  $50,145.  In  other  words,  if  we  include,  in  a 
credit  to  bonds,  profit  upon  bonds  sold,  we  thereby  decrease  upon 
the  books  the  apparent  value  of  the  bonds  remaining.  To  express 
the  same  thing  differently,  if  you  take  off  more  than  half,  the  re- 
mainder is  necessarily  less  than  half;  and  if  you  credit  the  bonds 
sold  for  more  than  the  book  value,  you  leave  the  bonds  remaining 
at  a  figure  less  than  the  book  value.  Your  effort  to  keep  your  book 
value  recorded  has  been  wasted.  The  escape  from  this  is  to  main- 
tain a  special  account.  Bond  Sales,  and  when  bonds  are  sold  debit 
it  for  the  book  value  of  the  bonds  and  credit  it  for  the  selling  price. 
This  leaves  on  the  bond  ledger  the  remaining  bonds  standing  at 
their  exact  book  value  and  Bond  Sales  showing  a  profit  or  a  loss  of 
the  difference  between  selling  price  and  book  value.  Hence  at  the 
end  of  any  period  it  is  easy  to  see  exactly  what  has  been  the  profit 
or  the  loss  upon  the  sale  of  bonds ;  whereas  if  this  account  were  not 
maintained  and  sales  price  were  confused  with  book  value  in  the 
account  of  each  class  of  bonds,  not  only  would  book  value  be  lost, 
but  an  inventory  of  all  bonds  would  be  necessary  before  one  could 
determine  profit. 

Finally,  something  like  a  tickler  should  be  kept,  usually  on  cards, 
showing  what  securities  or  real  estate  should  bring  in  interest  or 
dividends  or  rents  at  certain  dates. 

The  balance  sheet  of  a  trust  company  or  trust  department  of  a 
larger  institution  would  have  but  few  items,  but  these  items  should 
be  arranged  in  such  fashion  as  to  show  the  terms  under  which  the 


260  ACCOUNTS 

assets  are  held.  For  instance,  on  the  credit  side  of  the  balance  sheet, 
the  trusts  should  be  divided  by  classes,  showing  the  terms  under 
which  they  are  held,  as,  for  example :  — 

As  Executor 
As  Administrator 
As  Guardian 
As  Receiver 
As  Agent 
etc. 

On  the  debit  side  it  is  desirable  that  the  classes  of  investment  should 
be  designated  somewhat  as  follows :  — 

Registered  bonds 
Coupon  bonds 
Stocks 
Mortgages 
Collateral  loans 
etc. 

Many  trust  companies  maintain  a  separate  department  for  cor- 
porate trusts,  serving  corporations  in  such  work  as  paying  dividends, 
paying  interest,  transferring  stock,  holding  bonds  as  collateral  for 
the  security  of  collateral  trust  bonds.  Where  much  of  this  business 
is  done,  the  balance  sheet  may  well  be  divided  into  two  parts,  in- 
dividual trusts  and  corporate  trusts,  reporting  the  assets  separately 
for  each. 

It  is  worth  while  to  observe  actual  entries  for  a  series  of  trust 
transactions.  These  will  show  not  only  the  mechanical  processes 
of  record  but  the  accounting  principles  involved. 

Let  us  suppose  to  be  taken  over  an  estate  consisting  of  $100,000 
par  value  of  coupon  bonds,  appraised  for  probate  purposes  at  $110,- 
000,  real  estate  appraised  at  $50,000,  and  cash  on  deposit  $5000. 
The  first  entry  on  the  books  of  the  trust  company  follows: 

Trust  Coupon  Bonds  $110,000 

Trust  Real  Estate  50,000 

Cash  5,000 

To  Executorship  Trust  Principal  $165,000 

On  the  executorship  trust  ledger,  a  subordinate  ledger  controlled 


i 


PRINCIPLES  ILLUSTRATED  IN  TRUST  ACCOUNTING       261 

by  the  general  ledger  account,  in  the  group  of  columns  for  Principal 
will  be  posted  a  credit  of  $165,000,  and  in  that  for  Investment  will 
be  posted  a  debit  of  $160,000.  [See  page  256.]  On  the  coupon  bond 
ledger,  a  subordinate  ledger  controlled  by  the  general  ledger  ac- 
count, will  be  posted,  under  the  head  of  the  proper  bond  issue,  a 
debit  of  $110,000.  A  posting  will  be  made  also  to  a  subordinate 
real-estate  ledger,  which  should  have  columns  for  rentals  due, 
rentals  received,  and  expenses  incurred. 

When  the  interest-date  on  the  bonds  arrives,  an  entry  is  made 
for  these  bonds,  with  all  others  bearing  interest  on  the  same  day, 
debiting  Trust  Interest  Due  and  crediting  Trust  Interest  Accrued. 
This  is  posted  not  only  to  the  general  ledger  accounts,  but  to  the 
interest-due  columns  of  the  bond  ledger.  When  the  interest  is  paid, 
the  entry  is  a  credit  to  Trust  Interest  Due  and  a  debit  to  Cash. 
The  proper  entry  is  then  made  for  adjustment  of  interest  accrued 
between  Executorship  Trust  Income  (virtually  Interest  Earned), 
Amortisation,  Accumulation,  and  Commission,  and  this  also  is 
posted  not  only  to  the  general  ledger  but  to  the  bond  ledgers  (in- 
terest paid  and  amortisation)  and  to  the  individual  trust  ledgers 
(affecting  usually  both  income  and  investment).  In  this  case,  if 
we  assume  the  bonds  to  pay  5%  (semi-annual  instalments)  and 
amortisation  to  be  $125,  we  shall  on  the  individual  trust  ledger 
enter  as  gross  income  $2500,  as  Commission  (supposing  the  rate 
to  be  5%)  $125,  as  a  debit  to  Income  (for  amortisation)  $125,  and 
as  a  credit  to  Investment,  $125.  This  gives  to  Income  a  balance 
of  $2250,  to  Investment  a  writing  down  of  $125,  and  to  uninvested 
cash  (the  difference  betw^een  Principal  and  Investment)  an  in- 
crease of  $125. 

If  now  repairs  are  made  on  the  real  estate,  the  entry  is  a  debit 
to  Executorship  Trust  Income  (say  $200),  and  it  must  be  posted 
to  both  the  trust  ledger  (income  debit)  and  to  subordinate  columns 
in  the  real  estate  ledger  corresponding  to  the  interest  columns  of 
the  bond  ledger  and  kept  for  reference  purposes. 

When  rent  is  paid  on  the  real  estate  (say  $1250),  the  general  led- 
ger gets  a  credit  to  Executorship  Trust  Income  and  to  Commission, 
and  the  trust  ledger  gets  a  credit  for  gross  income  and  a  debit  for 
commission,  and  the  real  estate  ledger  gets  a  memorandum  of  the 
payment  of  rent.   If  much  real  estate  is  handled,  it  may  pay  to 


262  ACCOUNTS 

keep  accounts  for  Trust  Rents  Due,  and  Tiust  Rents  Accrued, 
similarly  to  Trust  Interest. 

If  now  the  income  ($3237.50)  is  to  be  added  to  principal,  a  debit 
to  Executorship  Trust  Income  and  a  credit  to  Executorship  Trust 
Principal  on  the  general  books,  with  corresponding  postings  in  the 
trust  ledger,  will  serve  the  purpose. 

Finally,  if  half  the  bonds  are  sold  for  $55,000,  Executorship 
Trust  Principal  will  be  credited  for  $62.50  (the  gain),  and  Trust 
Coupon  Bonds  for  $54,937.50  (half  the  book  value  of  the  bonds); 
and  Cash  will  be  debited  for  $55,000.  On  the  trust  ledger.  Invest- 
ment will  be  credited  $54,937.50,  and  Principal  will  be  credited 
$62.50  (for  this  gain  is  not  income  but  capital).  The  trust  company 
gets  its  commission  out  of  the  subsequent  increased  income  from 
the  increased  capital.  The  bond  ledger,  too,  must  get  a  credit  for 
$54,937.50  in  the  account  representing  the  bonds. 

This,  it  will  be  noticed,  gives  a  difference  between  principal  and 
investment  of  $63,362.50,  which  is  the  amount  of  cash  belonging 
to  the  trust. 

The  general  ledger  of  the  trust  company  shows  for  these  trans- 
actions the  following  trial  balance  figures,  agreeing  with  the  indi- 
vidual trust  figures. 


Executorship  Trust  Principal 

$168,300.00 

Trust  Coupon  Bonds 

$54,937-50 

Trust  Real  Estate 

50,000.00 

Commission 

187.50 

Cash 

63,550.00 
$168,487.50 

$168,487.50 

The  excess  of  cash  over  the  cash  balance  of  the  trust  is  the  com- 
mission earned  by  the  company. 


CHAPTER  EIGHTEEN 

SOME   PECULIARITIES   OF   ACCOUNTING   FOR   INSURANCE 
AND  FOR   LIFE  TENURES 

One  of  the  commonest  types  of  annuity,  of  which  the  principle  was 
discussed  in  Chapter  XII,  is  attached  to  life  insurance  poHcies. 
Though  it  is  a  rather  common  thing  for  a  life  insurance  company 
to  issue  annuities  for  a  definite  number  of  years,  this  is  done  usually 
independent  of  the  life  insurance  business,  —  as  any  other  financial 
institution  might  issue  such  annuity.  The  normal  form  of  annuity 
in  connection  with  life  insurance  is  not  an  annuity  which  the  com- 
pany sells  but  one  which  it  buys,  —  namely,  annual  premium  on 
policies.  This  affords  an  excellent  illustration  not  only  of  the  method 
of  annuities,  but  also  of  a  striking  type  of  deferred  liability.  It  will 
be  worth  while,  therefore,  to  examine  in  some  detail  the  principle 
upon  which  life  insurance  is  founded. 

At  the  basis  of  all  is  the  question  of  expectation  of  life.  The  work 
of  determining  how  long  a  man  is  likely  to  live  devolves  upon  mathe- 
maticians who  are  usually  called  "  actuaries."  From  elaborate  tables 
of  vital  statistics  accumulated  from  many  years  of  experience  they 
have  learned  how  many  men  out  of  every  thousand  are  likely  to 
survive  to  a  specified  age.  If,  for  example,  the  statistics  of  the  nine- 
teenth century  show  that  of  every  thousand  men  thirty-two  years 
of  age  ten  died  in  the  first  year,  eleven  in  the  second  year,  and  so  on, 
it  is  a  fair  assumption  that  something  Hke  the  same  numbers  will 
die  in  the  years  of  the  twentieth  century,  allowing,  of  course,  for  im- 
proved medical  and  surgical  skill ;  and  it  is  possible  on  such  a  basis 
to  figure  the  reasonable  expectation  of  life  for  any  man  at  any  age. 

The  method  of  determining  the  amount  of  annual  premium,  or 
annuity  for  life,  which  any  man  shall  pay  for  a  life  insurance  policy 
promising  to  pay  a  definite  sum  at  death  can  be  best  explained 
after  determining  the  sum  which  would  be  necessary  to  buy  what  is 
called  a  paid-up  policy,  —  by  which  is  meant  a  sum  paid  down  once 
for  all  to  insure  the  man  for  life.  A  certain  table  shows  that  of  84,- 


h 


264  ACCOUNTS 

000  men  at  the  age  of  thirty- two,  723  will  die  in  the  first  year.  What 
will  be  the  cost,  then,  of  insuring  84,000  men  at  the  age  of  thirty- two 
for  $1000  each  for  one  year  ?  If  the  insurance  is  to  terminate  at  the 
end  of  the  first  year,  the  only  liability  which  the  company  assumes 
is  to  pay  $723,000  for  that  year.  The  amount  paid  by  those  who  take 
out  policies  is,  of  course,  to  be  paid  at  the  beginning  of  the  year.  We 
cannot  determine  the  days  at  which  the  death  claims  will  become 
due ;  but,  for  the  purpose  of  illustrating  our  principle,  let  us  assume 
that  at  whatever  time  the  death  occurs  the  claim  on  the  policy  will 
be  made  at  the  end  of  the  year.  It  is  obvious,  then,  that  in  order  to 
enable  the  company  to  insure  these  84,000  men  for  one  year,  such  a 
sum  must  be  paid  by  each  at  the  beginning  of  the  year  as  will  pro- 
duce $723,000  at  the  end  of  the  year.  The  expenses  of  conducting 
the  business  we  may  omit  from  our  calculation  for  the  present.  We 
have,  then,  only  to  divide  our  $723,000  by  84,000,  and  then  see  what 
sum  invested  for  one  year  will  amount  to  that  quotient.  The  quo- 
tient in  this  case  is  $8.61 ;  but  since  $1.00  invested  for  a  year  will  on 
a  4%  basis,  which  we  may  assume  here,  amount  to  $1.04,  it  will 
take  but  $8.28  invested  at  the  beginning  of  the  year  to  produce  $8.61 
at  the  end  of  the  year.  Consequently  the  cost  of  insurance  for  these 
84,000  men  for  one  year  is  $8.28  each.  The  same  sort  of  process  ap- 
plied to  the  second  year  gives  us  $726,000  to  raise,  for  in  the  second 
year  a  larger  number  of  deaths  will  occur;  this  gives  $8.64  for  each 
man,  but  when  this  last  figure  is  divided  by  the  amount  of  $1.00 
invested  for  two  years,  which  is  actually  $1.0816,  we  get  a  cost  for 
each  man  of  $7.99.  This  cost  for  the  second  year,  if  added  to  the 
cost  for  each  man  for  the  first  year,  will  show  us  the  cost  of  insuring 
each  of  84,000  men  for  two  years,  or  $16.27.  The  same  process  for 
the  third  year,  with  729  deaths,  gives  $8.68  direct  cost  for  each  man, 
which,  less  the  accumulation  of  interest  for  three  years,  produces 
a  net  cost  of  $7.72.  If,  now,  this  process  is  continued  for  every  year 
in  which  any  of  the  original  84,000  men  shall  be  living,  the  total  is 
the  cost  of  insurance  per  man  for  life.  This  is  actually  $308.71.  This 
is  the  cost  of  a  paid-up  policy  for  men  at  the  age  of  thirty-two,  as- 
suming payment  to  be  made  at  the  time  the  policy  is  taken  out ;  and 
this  sum  paid  by  each  man  will  yield  sufficient  money,  if  the  expecta- 
tion of  life  proves  exactly  true,  to  pay  the  last  $1000  at  the  time 
that  the  last  of  the  84,000  men  shall  die.^ 


INSURANCE  AND  LIFE  TENURES  265 

It  is  obvious,  however,  that  the  average  man  is  not  able  to  buy  a 
paid-up  policy.  It  is  the  desire  and  the  necessity  of  most  men  to  pay 
insurance  from  income;  and,  therefore,  this  paid-up  sum  of  $308.71 
must  be  converted  into  an  annuity;  and  we  can  best  illustrate  the 
principle  by  assuming  that  the  payment  of  the  annuity  is  to  continue 
during  the  man's  life,  though  many  policies  are  made  out  for  a  lim- 
ited number  of  payments.  Since  the  cost  to  the  company  is  $308.71 
for  each  of  the  84,000  men,  the  total  cost  or  total  paid-up  insurance 
will  be  $25,931,640.  We  have  now  to  determine  what  annual  pre- 
mium paid  for  life  by  each  of  the  men  will  produce  this  figure.  Since 
we  are  to  convert  a  present  sum  into  future  payments,  we  have  a 
double  allowance  to  make:  since  the  premiums  are  life  annuities, 
every  death  means  the  termination  of  one  of  the  annuities ;  but  all 
paid  annuities  are  accumulating  interest.  In  order  to  determine  how 
many  dollars  each  man  must  pay,  we  may  best  take  $1.00  as  a  basis 
and  learning  the  amount  of  an  annuity  of  that  sum  divide  our  $25,- 
931,640  by  it  and  thus  learn  how  much  should  be  the  annual  pre- 
mium to  produce  the  result  we  are  aiming  at.  The  first  premium  will 
be  paid  by  84,000  men,  for  all  will  be  living  at  the  time  of  taking  out 
the  policies.  The  amount  of  the  first  premium  on  a  $1.00  supposi- 
tion is  $84,000.  At  the  end  of  the  first  year,  as  we  have  already  seen, 
723  men  will  have  died ;  and  consequently  83,277  will  pay  the  second 
premium.  This  second  premium,  however,  being  paid  only  at  the 
end  of  one  year,  cannot  be  set  off  dollar  for  dollar  against  the  cost 
of  the  paid-up  policy  with  which  we  started,  for  a  dollar  to  be  paid 
at  the  end  of  the  year  is  worth  but  $.9615;  and  consequently  the 
present  worth  of  the  premium  paid  by  the  83,277  men  will  be  but 
$80,070.84.  At  the  end  of  the  second  year,  726  additional  men  will 
have  died;  and  consequently  but  82,551  will  remain  to  pay  pre- 
miums, and  the  premiums  which  they  pay,  being  due  only  after 
two  years,  will  have  a  present  worth  of  not  $1.00  but  only  of  that 
sum  which  it  will  take  to  produce  $1.00  at  the  end  of  two  years, 
namely,  $.9245;  so  their  payments  will  amount  to  $76,318.40.  At 
the  end  of  the  next  year,  729  additional  men  will  have  died,  leaving 
81,822  to  pay  premiums.  But  these  premiums  are  to  be  paid  only 
at  the  end  of  three  years,  worth  each  but  $.8890,  or  a  total  of  $72,- 
739.76.  This  process  carried  through  the  whole  time  until  the  last 
man  shall  have  died  will  produce  $1,509,408.62,  on  the  assumption 


266  ACCOUNTS 

that  each  premium  is  $i.oo.  Now,  dividing  our  $25,931,640  by 
our  $1,509,408.62,  we  get  the  amount  of  premium  necessary  to  realize 
the  total  amount  required,  or  $17.18.  This,  then,  exclusive  of  ex- 
pense and  assuming  death  claims  to  be  payable  only  at  the  end  of 
each  year,  is  the  annual  premium  required  to  insure  a  man  at  the 
age  of  thirty-two  for  $1000  for  life. 

Now  appears  what  seems  at  first  glance  to  be  a  striking  incon- 
sistency. We  found  the  cost  of  insurance  for  the  first  year  to  be 
$8.28;  but  we  have  just  shown  that  the  premium  for  the  first  year 
as  for  all  years  must  be  $17.18.  This  discrepancy  between  the  first 
table  of  cost  and  the  final  conclusion  with  regard  to  the  annual 
premium  underlies  the  important  matter  of  life  insurance  reserves 
—  a  matter  often  misunderstood.   This  we  must  now  examine. 

The  first  figuring  of  cost  was  on  the  basis  of  a  paid-up  insurance, 
assuming  that  every  man  of  the  84,000  paid  something,  at  the  time 
of  insuring,  for  every  year,  including  that  when  the  last  man  should 
die.  When  we  come  to  convert  this  payment  into  an  annuity,  how- 
ever, only  in  the  first  year  will  84,000  men  pay  any  premium.  Enough 
must  be  accumulated,  therefore,  in  the  early  years,  when  the  deaths 
are  comparatively  few,  to  offset  the  large  number  of  death  claims 
in  the  later  years,  when  the  premiums  are  comparatively  few.  This 
can  perhaps  be  best  made  clear  by  considering  the  comparative  re- 
ceipts and  expenditures  in  the  last  year  of  the  duration  of  the  poli- 
cies. Let  us  suppose  that  the  last  man  of  the  84,000  survives  one 
year  longer  than  any  other.  The  receipts  of  the  company  from 
premiums  in  that  year  will  be  obviously  $17.18,  because  that  is  the 
annual  premium  and  there  is  but  one  survivor.  The  expenditure 
for  that  year,  however,  when  that  death  claim  matures,  will  be 
$1000.  In  other  words,  the  expenditure  will  be  fifty-eight  times 
the  receipt.  In  that  year  the  ratio  of  deaths  to  premiums  will  be  i :  i. 
In  the  first  year  it  was  i  :ii6.  The  necessity  for  a  reserve  accumu- 
lated in  the  earlier  years  to  meet  excess  of  payments  in  the  later 
years  needs  no  further  illustration. 

It  is  obvious  that,  unless  some  error  is  made  in  the  rate  of  inter- 
est assumed  to  be  earned  by  the  premium  or  in  the  number  of  deaths 
assumed  to  occur  in  each  year,  exactly  enough  reserve  will  have 
been  accumulated  on  the  plan  explained  above  to  meet  the  re- 
quirements for  the  life  of  the  policies.  To  put  the  thing  in  another 


INSURANCE  AND  LIFE  TENURES  267 

way,  if  an  insurance  company  should  discontinue  writing  policies 
and  should  do  no  other  business  than  to  collect  premiums  upon  the 
policies  already  written  and  to  pay  the  death  claims  as  they  mature 
(expense  is  left  out  of  account),  it  could  perfectly  well  meet  all 
death  claims  out  of  its  funds ;  for  the  money  is  in  its  hands  or  pro- 
vided to  be  in  its  hands  in  sufficient  amounts  at  the  proper  time. 
Indeed,  the  company  could  at  any  time  return  to  its  policy-holders 
the  reserve  which  has  accumulated  from  their  premium  payments, 
cancelling  the  remaining  policies,  without  loss  other  than  the  ex- 
pense of  conducting  the  business  up  to  the  time  of  cancellation. 

Except  so  far  as  large  numbers  increase  the  probability  of  fair 
averages,  it  is  obvious  that  a  cry  for  increased  business  is  without 
warrant  on  the  theoretical  principles  of  insurance;  and  where  it 
occurs  some  other  motive  must  be  found  than  any  connected  with 
insurance  proper.  As  a  matter  of  fact,  three  such  motives  have  been 
operative. 

So  far  our  figures  have  disregarded  the  expenses  of  insurance. 
Yet  merely  to  collect  premiums,  to  invest  the  reserve,  and  to  pay 
death  claims  involves  an  amount  of  clerical  expense,  medical  fees, 
and  administration  charges,  sure  to  amount  to  a  large  figure.  Every 
insurance  company  therefore  adds  to  each  pure  premium  a  certain 
figure  for  what  is  called  "loading,"  or  expenses.  Each  company 
has  its  own  figure,  and  the  variation  between  companies  is  wide. 
Obviously,  a  big  business  can  be  conducted  more  cheaply  than  a 
small  one,  and  in  mutual  companies  properly  managed  an  increase 
in  business  means  cheaper  insurance.  This  furnishes  a  motive  that 
cannot  be  questioned. 

It  is  equally  obvious  that  in  proprietary  companies  the  bigger 
the  business  the  greater  is  the  excess  of  the  loading  fund  over  the 
actual  cost,  and  the  greater  is  the  profit  of  the  proprietors.  Recent 
public  investigations  have  shown  very  clearly  that  even  in  mutual 
companies  when  immense  sums  have  to  be  expended  things  which 
ordinary  policy-holders  deem  of  great  consequence  are  likely  to 
appear  trivial  and  to  be  lightly  treated.  Many  high  officials  seem 
to  try  to  escape  the  trivialities  of  small  affairs.  A  large  loading  fund 
relieves  them  of  care  about  economy  in  salaries,  commissions,  fees, 
rents,  etc. 

The  third  motive  for  increasing  business  lies  in  the  use  of  the 


268  ACCOUNTS 

increased  reserve.  Even  assuming  a  high  degree  of  honesty  on  the 
part  of  officials,  the  task  of  investing  increasing  millions  of  policy- 
holders' money  gives  them  financial  prestige  as  important  influences 
in  the  money  market.  Such  prestige  is  worth  a  great  deal,  even  in 
absolutely  honorable  ways,  for  it  gives  a  man  in  his  private  capacity 
opportunities  that  he  would  not  otherwise  meet.  To  one  with  a 
flexible  conscience  the  field  for  financial  operations  is  almost  un- 
limited. 

Various  forms  of  insurance  policies  other  than  the  pure  type  ex- 
plained in  the  early  part  of  this  chapter  are  commonly  issued,  — 
such  as  the  endowment,  which  provides  that  the  policy  shall  mature 
at  the  latest  at  a  certain  date.  The  principle  is  the  same  as  in  the 
other  case ;  the  difference  is  simply  that  the  annuity  has  fewer  periods 
and  the  maximum  maturity  is  shorter. 

Most  companies  attempt,  of  course,  to  put  their  calculations  on 
such  a  basis  that  the  premium  accumulations  will  be  ample  for 
the  reserve;  and  the  mutual  companies,  planning  to  reduce  the  cost 
of  insurance  to  the  minimum,  return  to  their  policy-holders  any 
excess  which  the  transactions  of  the  year  have  shown  the  premiums 
to  provide.  This  is  commonly  done  by  an  annual  distribution,  which 
usually  can  be  applied  in  any  one  of  several  ways,  —  a  cash  rebate, 
application  upon  next  year's  premium,  increase  in  the  amount  of 
the  policy,  or  a  reduction  in  the  number  of  years  before  the  payment 
of  an  endowment.  Some  companies  retain  this  excess  as  a  "deferred 
dividend  "  until  the  maturity  of  the  pohcy. 

The  old-fashioned  tontine  system,  by  which  defaulting  policy- 
holders lose  all  their  accumulated  reserve  as  well  as  all  deferred 
dividend,  is  now  practically  discontinuing.  The  tendency  nowadays 
is  not  only  to  give  to  all  policies  a  cash  surrender  value,  equivalent 
to  the  accumulated  reserve  less  a  sum  for  expenses,  but  even  to  make 
them  non-forfeitable,  so  that  insurance  is  automatically  extended 
for  what  additional  insurance  the  reserve  would  buy,  —  either  full 
insurance  for  a  few  years,  or  a  small  insurance  for  life. 

It  is  obvious  from  this  discussion  that  the  balance  sheet  of  an 
insurance  company  will  be  entirely  unHke  any  other  balance  sheet 
so  far  considered.  For  an  insurance  company  to  put  into  the  balance 
sheet  as  a  liability  the  face  value  of  all  policies  written  is  to  produce 
a  figure  which  it  would  be  impossible  to  match  with  assets.   The 


INSURANCE  AND  LIFE  TENURES  269 

Kability  on  account  of  policies  is  considered  to  be  merely  the  reserve 
accumulated  on  those  policies.  The  amount  of  tliis  reserve  is  usually 
prescribed  by  state  law.  Against  this  liability  will  appear,  of  course, 
the  investment  of  accumulated  reserve. 

A  life-insurance  balance  sheet  shows  many  other  peculiarities 
due  primarily  to  the  nature  of  its  reserve.  Most  companies  allow 
policy-holders  to  give  short-term  notes  in  Heu  of  premium-pay- 
ments. They  can  afford  to  do  so,  for  after  the  first  two  or  three 
years  the  reserve  already  accumulated  on  the  policies  is  ample  se- 
curity. So  premium  notes  sometimes  form  a  considerable  item  on 
their  balance  sheets. 

One  secure  form  of  investment  of  reserve  is  loans  to  policy- 
holders, for  if  the  loan  never  exceeds  the  reserve  accumulated  the 
company  is  secured  by  the  policy:  in  other  words,  it  lends  to  the 
policy-holder  what  it  is  holding  for  him,  and  if  he  defaults  its  lia- 
bility to  him  ceases;  but  if  he  pays,  the  loan  is  a  good  investment. 
So  loans  to  policy-holders  is  likely  to  be  a  large  item. 

Often  the  form  of  death-claim  is  an  annuity  rather  than  a  single 
payment  for  the  beneficiary.  Then  there  is  a  liability  for  future 
payments  on  matured  Dolicies,  and  this  must  appear  on  the  bal- 
ance sheet. 

Of  other  sorts  of  insurance  it  is  hardly  necessary  to  say  anything 
here.  In  practically  all  other  kinds,  the  risk,  unlike  the  risk  in  life 
insurance,  is  constant,  for  loss  by  accidents,  fire,  etc.,  is  not  hkely 
to  be  considerably  larger  in  one  year  than  in  another,  and  so  a 
reserve  such  as  is  required  for  H<^e  insurance  is  unnecessary.  Usually 
a  reserve  is  kept,  of  course,  as  in  all  good  businesses,  but  it  differs  in 
nature  hardly  at  all  from  that  maintained  by  railroads  and  other 
large  corporations.  It  is  chiefly  a  safety  fund  to  meet  extraordinary 
losses. 

The  principles  of  life  insurance  are  more  likely  to  appear  in  or- 
dinary business  than  a  casual  observer  realizes,  for  many  business 
transactions  involve  an  estimate  of  expectation  of  life.  For  instance, 
no  one  can  intelligently  purchase  or  sell  the  widow's  right  of  dower 
in  a  piece  of  real  estate  without  an  appreciation  of  the  fact  that  not 
only  the  expectation  of  life,  but  the  present  worth  of  an  annuity, 
must  be  at  the  basis  of  the  calculation  of  value. 


CHAPTER  NINETEEN 

SOME    GENERAL   PRINCIPLES   ILLUSTRATED   IN    FACTORY 

ACCOUNTING 

The  characteristic  of  factory  accounting  as  distinguished  from  the 
other  sorts  already  discussed  is  that  most  of  the  cost  is  exact  and 
can  be  directly  connected  with  the  product,  though  a  considerable 
percentage  —  much  lower  than  in  transportation,  however  —  is  of 
a  general  sort  and  must  be  distributed  to  the  different  items  of  pro- 
duct on  a  somewhat  arbitrary  basis. 

The  first  distinction  between  the  different  elements  of  cost  in  man- 
ufacturing should  be  between  manufacturing  cost  and  selling  cost. 
No  relation  exists  between  them.  Either  the  manufacturing  division 
or  the  selling  division  may  be  excellently  managed  and  yet  the  busi- 
ness as  a  whole  produce  no  profit.  On  the  other  hand,  either  division 
may  be  poorly  managed  and  yet  the  business  as  a  whole  produce 
a  good  profit.  Only  when  absolute  distinction  is  made  between  them 
is  it  possible  to  place  responsibility.  Let  us  begin  with  the  producing 
cost. 

Producing  cost  for  each  article  of  product  is  commonly  divided 
into  three  parts :  first,  material ;  second,  labor ;  third,  what  is  com- 
monly called  ''burden."  Burden  is  the  share  of  general  expenses, 
such  as  salaries  for  superintendence,  heat,  power,  insurance,  taxes, 
etc.,  —  expenses  incurred  not  for  a  particular  article  but  for  the 
factory  as  a  whole,  so  that  each  particular  article  gets  the  benefit. 
It  furnishes  an  illustration  of  a  pure  joint  cost,  such  as  was  discussed 
in  Chapter  X.  The  cost  of  material  and  the  cost  of  labor  on  each 
article  of  product,  however,  can  usually  be  determined  exactly  if 
enough  care  is  taken  in  keeping  the  records.  We  may  well  begin 
with  these,  therefore,  which  are  commonly  called  prime  costs  or 
direct  costs. 

Our  first  illustration  may  be  taken  from  a  factory  making  goods 
of  many  types,  chiefly  on  orders.  It  is  obvious  that  shop  foremen 
must  keep  records  of  all  materials  used  and  of  all  labor  employed 
for  every  piece  of  work.  It  happens  that  in  most  complicated  kinds 


PRINCIPLES   ILLUSTRATED  IN  FACTORY  ACCOUNTING    27I 

of  manufacturing  care  requires  that  for  every  piece  of  work  a  writ- 
ten order  shall  be  given  to  the  men  who  are  responsible  to  produce 
it,  so  that  error  may  be  avoided  in  quantity,  quality,  and  dimension. 
Such  orders  furnish  an  excellent  basis  for  accounting.  Not  only 
must  orders  be  made  for  work  as  a  whole,  but  usually  it  is  desirable 
whenever  a  job  is  cut  into  several  pieces  that  a  separate  order  shall 
be  given  to  every  man  having  part  in  it ;  and  these  smaller  orders,  or 
"job  orders"  as  they  are  often  called,  may  furnish  a  basis  for  minor 
accounting. 

Let  us  take  for  our  illustration  the  manufacture  of  a  steam  engine. 
Our  first  concern  is  with  the  material  entering  into  it.  Usually  when 
material  is  purchased  the  ultimate  destination  of  it  is  not  known; 
so  Stores  is  debited.  A  well-managed  factory  will  have  always  on 
hand  a  large  store  of  material  in  addition  to  the  particular  raw  ma- 
terial required  for  its  main  product.  That  is  to  say,  a  large  shoe 
factory  will  maintain  on  hand  a  stock  of  lumber,  hardware,  etc., 
in  addition  to  its  stock  of  leather  and  findings.  The  stores  account 
in  the  general  ledger  is  but  a  summary  of  many  elaborate  details 
kept  elsewhere.  Most  concerns  keep  what  is  called  a  "  stores  ledger,'^ 
in  which  is  entered  every  receipt  of  goods  at  the  storehouse  and  every 
issue  of  goods  from  it.  This  record  is  kept  accurate  by  requiring  the 
storekeeper  to  give  a  receipt  for  everything  he  receives  and  to  ob- 
tain a  receipt  for  everything  he  issues.  A  stores  ledger  is  arranged 
in  such  a  way  that  each  kind  of  article  maintained  in  stores  has  an 
allotted  page  or  pages  exactly  as  each  account  has  a  page  in  an  or- 
dinary ledger ;  and  all  supplies  of  that  sort  received  are  debited  and 
all  supplies  issued  are  credited.  Spaces  are  provided  to  distinguish 
even  between  different  lengths  and  sizes  of  screws,  nails,  lumber, 
etc.  Under  this  method  it  is  unnecessary  for  the  superintendent  or 
other  officers  to  get  special  reports  from  the  storehouse  to  learn  what 
stock  is  on  hand.  A  properly  arranged  stores  system,  moreover,  will 
have  recorded  usually  on  the  stores  ledger  a  statement  of  the  mini- 
mum stock  desired,  and  also  a  statement  of  what  is  considered  a 
standard  order  for  the  replenishment  of  stores.  It  becomes  the  duty 
of  the  storekeeper  under  this  system  to  notify  the  purchasing  officers 
whenever  any  article  of  stores  approaches  its  stated  limit.  Under 
this  plan,  there  is  no  danger  that  —  except  in  extraordinary  cases, 
which  should  be  foreseen  by  the  proper  department  —  delays  will 


272  ACCOUNTS 

occur  because  of  improper  preparation.  It  is  inevitable  that  there 
shall  be  a  certain  shrinkage  or  overrunning  in  the  supplies  on  hand ; 
and  it  is  necessary  at  occasional  intervals  to  compare  the  actual 
supplies  v^ith  the  record  in  the  stores  ledger.  In  other  v^ords,  it  is 
necessary  occasionally  to  take  account  of  stock.  This  stock-taking, 
hov^ever,  need  not  be  a  difficult  or  laborious  task,  for  it  does  not 
need  to  be  done  all  at  once.  Ordinarily,  of  course,  if  stock-taking 
is  attempted  while  business  is  going  on,  the  figures  obtained  at  the 
end  may  disagree  seriously  v^ith  the  actual  stock  at  any  one  time 
during  the  process.  Under  the  stores-ledger  system,  however,  it  is 
not  necessary  to  take  account  of  more  than  one  kind  of  goods  at  a 
time,  —  for  the  only  aim  is  to  correct  errors.  This  time,  moreover, 
may  be  at  the  convenience  of  the  estabUshment,  and  the  easy  time 
is  always  when  stores  are  lowest.  So  the  labor  of  stock-taking  is 
reduced  to  a  minimum.  Sometimes  one  stores  ledger  is  kept  by  the 
storekeeper,  and  another  independently  kept  in  the  office.  These 
are  compared  and  adjusted  at  suitable  intervals. 

The  next  question  for  the  superintendent  to  determine  is  whether 
the  factory  has  all  the  facilities  it  requires  for  the  construction  of  the 
steam-engine.  If  it  happens  that  the  concern  is  just  working  into 
the  building  of  engines  of  this  type  and  has  never  built  one  before, 
it  may  need  some  new  facility  that  will  be  serviceable  not  only  for 
this  order  but  for  many  others.  Suppose  it  needs  a  large  platform 
or  some  sort  of  permanent  portable  scaffolding  that  will  enable  the 
work  to  be  done  readily.  This  will  require  material  and  labor,  and 
for  them  orders  must  be  issued  to  the  foremen  of  the  necessary 
departments.  If  the  scaffolding  is  so  complicated  that  plans  are 
necessary,  an  order  will  be  sent  to  the  engineer's  department  to 
design  it.  Another  order  will  be  sent  to  the  drafting  department  to 
draw  plans  in  detail.  Finally  an  order  will  be  sent  to  the  carpen- 
ters' department  to  construct  it.  In  each  case  the  work  will  be  done 
by  authority  of  a  written  order,  and  each  order  will  bear  upon  its 
face  conspicuously  a  name  or  symbol  to  show  what  is  its  nature. 
In  this  case,  to  show  that  it  is  the  407th  order  for  the  construction 
of  equipment,  it  might  be  entitled  C.  E.  407.  All  the  orders  for  this 
construction,  to  whatever  department  they  go,  will  bear  the  same 
symbol.  When,  then,  the  work  is  finished  and  the  orders  have  been 
returned  to  the  bookkeepers,  the  symbol  upon  the  face  of  each  order 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    273 

indicates  to  what  account  charges  should  be  made.  In  this  case, 
since  the  work  is  for  construction  of  equipment,  a  charge  should  be 
made  to  Equipment,  or  some  similar  capital  account. 

Now  let  us  follow  through  some  details  of  this  order.  The  fore- 
man of  carpenters  may  find  it  desirable  to  cut  his  general  order  into 
several  job  orders.  He  may  order  one  man  to  cut  the  lumber  of  the 
right  dimensions;  another  to  cut  the  planks;  another  to  build  the 
steps ;  and  each  will  require  an  order  on  the  storekeeper  for  his  sup- 
plies. These  suppHes  will  be  acknowledged  by  the  men  receiving 
them,  and  on  the  stores  ledger  they  will  be  credited  to  the  accounts 
of  the  particular  supplies  given  out.  All  these  job  orders,  as  well  as 
the  general  orders,  will  bear  the  number  of  the  original  order  from 
the  superintendent,  that  is,  C.  E.  407.  The  men  working  upon  these 
job  orders  will  enter  upon  them,  as  soon  as  the  work  is  completed, 
the  number  of  hours  spent.  When,  therefore,  the  job  is  done,  a 
complete  record  is  available,  showing  all  stores  used  and  all  wages 
paid  on  account  of  this  order.  Excess  stores  returned  are  acknow- 
ledged and  entered  by  the  storekeeper  on  the  stores  ledger.  In  the 
office,  the  bookkeepers  enter  to  the  account  of  the  order  concerned, 
i.  e.,  C.  E.  407,  debits  for  stores  issued  and  for  labor,  and  credits 
for  stores  returned. 

If  the  superintendent  finds  that  in  preparation  for  carrying  out 
the  original  order  for  the  steam-engine  a  machine  must  be  repaired, 
he  issues  another  order  which  we  may  call  P.  R.  2563.  This  will 
be  interpreted  to  mean  the  2563d  order  for  plant  repairs.  This  again 
may  involve  many  materials  from  the  stores  department,  drawings 
from  the  drafting  department,  patterns  from  the  pattern  depart- 
ment, castings  from  the  foundry,  finishing,  setting  up,  and  what 
not.  In  other  words,  many  department  orders  and  many  job  orders 
will  be  given  and  all  will  bear  the  original  symbol,  P.  R.  2563.  These, 
as  in  the  case  of  the  construction  of  equipment,  will  be  carried 
through  the  various  records,  showing  what  total  cost  is  to  be  charged 
to  Repairs  of  Plant,  or  similar  maintenance  account. 

If  now  the  manufacture  of  the  engine  is  ready  to  begin,  the  orders 
for  it  are  given  a  symbol  to  indicate  that  the  work  is  for  outside 
business.  We  may  call  it  in  this  case  M.  423,  meaning  manufacturing 
order.  This  would  be  treated  similarly  to  those  already  followed, 
except  that  in  the  end  the  charges  would  be  made  to  Manufacturing. 


274  ACCOUNTS 

Here,  then,  are  the  chief  documents  from  which  the  office  gets 
its  information  of  prime  cost.  The  principal  books  to  which  in- 
formation from  these  documents  is  carried  are  as  follows :  first,  the 
stores  ledger,  already  described ;  second,  a  wages  book  (though  often 
loose  sheets  of  paper  rather  than  a  bound  book  are  used  for  this  pur- 
pose), showing  the  amount  of  credit  to  each  workman  for  his  time  or 
piecework  earnings ;  third,  a  cost  book,  arranged  with  ample  space  for 
each  order,  sometimes  several  pages  being  left  blank  at  the  begin- 
ning for  the  details  likely  to  enter  into  the  transaction  before  it  is 
completed ;  fourth,  the  general  books  common  to  all  business,  such 
as  a  general  journal,  a  cash  book,  a  sales  book,  a  purchase  book, 
and  finally  a  general  ledger. 

Let  us  now  trace  these  orders  through  the  books.  All  orders  upon 
the  storekeeper  are  entered  in  two  places,  —  in  the  stores  ledger 
and  in  the  cost  book.  In  the  former,  as  we  have  seen,  the  supplies 
issued  are  credited:  in  the  latter,  the  particular  order  is  debited. 
Next,  the  wages  item  that  has  been  entered  on  each  job  order  is 
carried  to  two  places,  —  the  wages  book  and  the  cost  book.  In  the 
wages  book  the  particular  workmen  are  credited  each  for  his  earn- 
ings. In  the  cost  book  each  order  is  debited  with  its  share  of  the 
wages  expense.  As  a  result,  we  now  have  entered  on  our  books  cost 
for  wages  and  for  material  in  respect  to  each  order,  and  we  also  have 
credits  for  stores  and  for  individual  workmen's  wages. 

One  other  important  matter  is  likely  to  remain.  Many  orders 
have  connected  with  them  some  direct  cash  or  other  expense  neither 
for  labor  nor  for  stores,  —  for  example,  telegraphing  or  traveling 
expenses.  Such  things  also  should  go  upon  the  cost  book  to  make 
the  record  of  cost  as  nearly  complete  as  possible.  They  will  be  taken, 
of  course,  from  whatever  source  will  serve,  —  usually  the  cash  book. 
Perhaps  certain  less  obvious  costs  will  pertain  to  certain  orders.  If, 
for  instance,  the  construction  of  a  machine  involves  risk  of  fire  so 
great  that  special  premiums  must  be  paid  on  the  factory  during  the 
work,  the  order  should  be  debited  for  the  extra  insurance  and  gen- 
eral insurance  account  should  be  credited,  so  that  at  the  end  of  the 
year  the  general  insurance  account  will  not  be  held  responsible  for 
the  thing  properly  belonging  to  one  specific  bit  of  construction.  If, 
again,  the  construction  involves  some  peculiar  process  very  much 
increasing  the  cost  of  repairs  for  any  part  of  the  plant,  such  loss 


I 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING    275 

should  be  debited  directly  to  the  order  and  credited  to  Plant  Re- 
pairs; for,  as  will  be  shown  later,  Plant  Repairs  should  represent 
the  indivisible  costs  as  an  element  of  "burden." 

It  is  obvious  that  in  the  general  ledger  it  is  not  necessary  to  keep 
account  with  specific  orders,  but  only  with  classes  of  orders.  These 
classes  are  likely  to  be  most  commonly  as  follows:  Additions  to 
Buildings,  Repairs  of  Buildings,  New  Equipment,  Repairs  of 
Equipment,  Office  Conveniences,  and  Manufacturing.  The  work 
is  much  simpHfied,  of  course,  when  a  separate  cost  book  is  kept  for 
each  class  of  order,  and  a  separate  column  provided  for  wages  and 
for  stores.  The  total  of  each  book  is  then  the  debit  to  the  ledger 
account  representing  the  class  of  order,  and  the  total  of  the  wages 
and  of  the  stores  columns  is  the  credit  to  Wages  and  to  Stores. 

It  may  be  well  at  this  point  to  note  two  interesting  auxiliary  books. 
The  "comparative  cost  register"  is  sometimes  used  to  keep  run  of 
the  comparative  cost  of  making  different  lots  of  articles.  If,  for 
example,  in  June  we  make  a  dozen  big  induction  coils  and  in  Feb- 
ruary make  a  similar  dozen,  it  is  well  to  compare  the  cost  in  detail, 
especially  if  the  work  was  done  by  different  workmen  or  under  dif- 
ferent methods.  In  this  register,  the  details  of  cost  for  the  con- 
struction of  both  lots  would  be  entered  in  parallel  columns,  possibly 
with  the  names  of  the  workmen  engaged.  A  comparison  enables  the 
manager  to  judge  at  a  glance  the  relative  efficiency  of  the  work.  This 
sort  of  thing  would  be  worth  while  only  for  standard  articles  made 
rather  often. 

Another  auxiliary  book  usually  desirable  to  keep  is  the  order 
ledger,  in  which  are  entered  all  the  separate  parts  of  the  order,  — 
sometimes  not  only  the  different  department  orders,  but  even  the 
job  orders  under  each.  These  may  be  checked  off  as  fast  as  the  slips 
are  returned  to  the  ofBce  for  entry,  so  that  at  all  times  the  condition 
of  the  order  is  recorded.  If,  also,  the  order  is  to  be  shipped  in  parts, 
a  complete  record  of  shipments  should  be  kept  for  immediate  refer- 
ence. By  this  method  it  is  possible  to  keep  careful  watch  of  the  situa- 
tion of  each  order ;  and,  when  contracts  specify  a  time  of  delivery, 
this  is  a  matter  of  great  importance. 

So  far  we  have  considered  chiefly  what  is  commonly  called 
prime  cost  or  direct  cost,  —  that  is,  labor  and  materials.  We  must 
now  approach  the  allocation  of  burden,  or  joint  cost,  —  that  is, 


276  ACCOUNTS 

rent,  insurance,  taxes,  interest,  superintendence,  administrative  ex- 
penses, etc.  The  distribution  of  this  burden  may  be  made  by  any 
plan  which  will  give  a  close  approximation  to  the  proportional  benefit 
which  each  order  has  received  from  these  different  elements  of  cost ; 
and  the  calculation  will  be  very  much  simplified  if  we  can  by  any 
method  attach  a  number  of  these  elements  to  one  specific  phase  of 
production.  It  happens  that  a  great  many  of  these  elements  of  bur- 
den are  directly  connected  with  the  cost  of  using  machinery.  We 
may  profitably,  then,  attach  as  many  as  possible  of  these  elements 
to  machine  use.  Then  those  that  cannot  be  so  attached  must  be 
allocated  on  another  basis. 

As  this  analysis  proceeds,  it  may  appear  to  those  unfamiliar  with 
this  sort  of  thing  that  here  is  "great  cry  and  little  wool."  The  de- 
scription of  the  process  is  perhaps  more  complicated  than  the  pro- 
cess itself.  Every  year  a  larger  number  of  manufacturing  establish- 
ments are  becoming  convinced  of  the  fact  that  the  necessity  for  de- 
termining costs  as  exactly  as  possible  is  nowadays  imperative.  They 
employ  at  great  expense  expert  accountants  to  analyze  their  busi- 
nesses, to  divide  the  different  processes  into  smaller  divisions,  and  to 
attach  to  each  its  specific  expense,  so  that  when  a  system  is  in  active 
operation  they  can  bid  upon  contracts  with  complete  confidence  in 
the  margin  of  profit.  It  is  only  because  competition  has  become 
intense  in  the  last  twenty  years  that  this  very  large  expense  of  or- 
ganizing accounting  has  been  thought  worth  while.  The  system 
described  below  cannot  perhaps  be  said  to  exist  in  exactly  this  form 
in  any  factory.  No  attempt  will  be  made  to  analyze  expense  in  any 
factory  to  the  last  degree,  but  only  to  indicate  the  general  principles 
upon  which  the  work  should  be  based.  Some  of  the  elem.ents  here 
introduced  may  be  in  many  factories  altogether  insignificant.  The 
distribution  of  burden  here  described  is  meant  to  be  not  a  model 
but  merely  illustrative. 

The  more  obvious  of  the  costs  connected  with  machinery  are  of 
four  classes,  as  follows:  first,  those  based  on  occupancy  of  space, 
which  we  will  call  space  cost ;  second,  those  based  on  the  cost  of  the 
machine  itself,  which  we  will  call  machine  cost ;  third,  those  based 
on  special  expense  connected  with  the  machine  when  in  operation 
(but  not  including  power),  which  we  will  call  machine-use  cost; 
fourth,  power  cost.   These  are  so  clearly  costs  of  the  work  of  the 


PRINCIPLES   ILLUSTRATED  IN  FACTORY  ACCOUNTING     277 

machines  that  no  question  can  arise  save  as  to  the  proportion  in 
which  each  order  receives  benefit  from  them;  and  it  is  interesting 
to  see  that  a  very  large  part  of  the  total  burden  to  be  distributed 
comes  under  one  or  more  of  these  four  classes. 

The  criterion  for  distributing  burden  over  production  on  the  basis 
of  use  of  machinery  is  clearly  time ;  for  the  same  machine  (when  in 
proper  repair)  will  always  be  capable  of  producing  the  same  results. 
Even  if  the  nature  of  a  job  requires  lower  speed,  and  loss  is  suffered, 
it  is  right  that  the  loss  should  be  charged  to  the  order  requiring  such 
reduced  speed  rather  than  to  the  machine  itself ;  for,  so  to  speak,  the 
loss  is  the  fault  of  the  job  and  not  of  the  machine.  We  intend,  there- 
fore, to  charge  each  job  with  cost  in  proportion  to  its  time- use  of  the 
above  four  expenses  for  machinery. 

Let  us  analyze  these  four  classes  of  cost  and  see  how  they  can 
attach  themselves  to  the  machines.  The  first,  or  space  cost,  will 
be  a  certain  proportion,  determined  by  the  machine's  occupancy  of 
space,  of  the  space  cost  of  the  entire  establishment.  For  instance, 
there  is  a  certain  ground  rent  for  the  land  occupied  for  the  whole 
establishment,  of  which  the  machine  shop  in  which  this  machine  is 
placed  receives  a  certain  benefit.  A  certain  portion  of  the  ground 
rent,  then,  may  be  divided  among  all  the  machines  in  the  machine 
shop  in  proportion  to  floor  space  occupied.  This  floor  space,  how- 
ever, is  not  determined  by  the  mere  floor  dimensions  of  the  ma- 
chine, but  is  the  space  necessary  for  its  most  successful  operation, 
with  room  for  operatives,  for  light,  for  feeding  materials  and  deliv- 
ering product,  for  passageways  to  and  from  it,  etc.  As  a  result  of 
this  subdivision,  then,  we  find  on  account  of  space  a  burden  of 
general  cost  which  this  machine  must  bear.  The  elements  of  that 
cost  are  usually  several.  First,  interest  on  investment  in  land  and 
buildings  must  be  met  (and  this  is  clearly  chargeable  whether  the 
company  owns  the  land  and  buildings  or  not,  for  whether  return  is 
to  be  made  to  landlords,  to  lenders  of  capital,  or  to  stockholders, 
the  jobs  must  produce  some  means  of  meeting  it).^  Second,  repairs 

*  There  has  been  much  discussion  over  the  treatment  of  rent  for  concerns  own- 
ing the  real  estate  that  they  use.  This  has  been  based  largely  on  the  economic 
theory  of  rent,  and  no  one  can  understand  the  discussion  without  an  understanding 
of  that  theory.  For  practical  purposes,  however,  the  matter  may  be  put  briefly  as 
follows : 

Rent  in  the  ordinary  use  of  the  word  is  composed  of  two  elements :  first,  payment 


278  ACCOUNTS 

to  buildings  are  really  a  part  of  the  costs  of  running  the  machines 
which  they  are  built  to  house.  Third,  depreciation  which  repairs 
cannot  prevent  must  be  provided  for.  Fourth,  taxes  on  land  and 
buildings  must  be  paid.  Fifth,  insurance  on  buildings  must  be  pro- 
vided. These  five  elements  —  interest,  repairs,  depreciation,  taxes, 
insurance  —  we  shall  have  occasion  to  mention  often,  for  they  arise 
in  many  connections,  and  we  may  therefore  call  them  the  five  normal 
elements.  Allied  to  these,  though  figured  on  a  somewhat  different 
basis,  are  two  new  elements,  —  heat  (which  must  be  charged  not 
in  proportion  to  floor  occupancy,  but  in  proportion  to  cubic  occu- 
pancy, for  that,  of  course,  determines  the  amount  of  heat  required), 
and  light  (which  should  be  distributed  not  on  the  basis  of  floor 

for  exceptional  advantages  accruing  to  the  owner  of  land  or  buildings  because  of 
location  or  other  natural  qualities  —  as  exceptional  shipping  facilities  or  low  power- 
cost;  second,  interest  on  the  improvements  made  on  the  land,  such  as  buildings.  In 
the  true  economic  sense,  rent  is  only  that  part  of  the  payment  which  is  due  to  the 
exceptional  facilities,  as  low  power-cost.  Obviously  rent  arising  from  such  advan- 
tages is  in  one  sense  not  cost  at  all,  but  a  measure  of  gain,  —  it  measures  the  saving 
by  having  the  use  of  this  special  facility.  Even  though  such  economic  rent  is  paid  to 
another,  it  comes  back  in  the  saving.  It  is  an  outgo,  but  it  is  offset  by  a  special  in- 
come —  or,  what  is  the  same  thing,  a  reduced  expense  elsewhere.  This  has  led  to 
the  theory  that,  at  least  for  the  manufacturing  concern  owning  the  land  and  buildings 
which  it  uses,  rent  need  not  be  included  in  the  schedules  of  cost. 

The  reply  to  this  lies  in  the  answer  to  the  question.  What  is  the  purpose  of  keeping 
manufacturing  accounts?  Unless  the  accounting  shows  not  only  a  basis  of  charges 
for  manufactured  goods,  but  also  what  are  the  gains  from  the  conduct  of  business, 
it  is  not  worthy  of  its  name.  If  the  concern  pays  rent,  clearly  the  rent  is  a  cost  —  as 
much  as  the  payment  for  wages :  in  both  cases  an  outgo  is  suffered  in  order  that  a 
return  may  be  secured.  If  the  concern  is  the  owner  of  the  property  that  it  uses,  two 
facts  require  that  rent  be  charged  as  a  cost.  First,  if  the  property  is  valuable  enough 
to  yield  economic  rent  (i.  e.,  more  than  interest  on  the  improvements  on  the  land), 
it  is  so  because  it  confers  some  advantage  in  lower  costs,  —  as  cheap  power  or  low 
freights  If,  then,  rent  is  excluded  from  costs  and  the  cost  book  shows  only  actual 
cost  paid  to  outsiders  by  the  business,  prices  based  on  the  cost  book  give  to  the 
customer  all  the  advantages  of  the  cheap  power  or  the  low  freight.  Such  prices 
are  not  normal  and  can  never  long  continue.  The  only  way  to  show  the  facts  is  to 
show  that  the  cheapness  of  power  or  of  freight  is  abnormal,  and  this  can  be  done 
by  entering  rent  as  one  of  the  costs.  Second,  the  concern  is  in  this  case  not  merely 
engaged  in  manufacturing;  it  is  a  landholder,  and  as  such  it  receives  a  landholder's 
revenue  as  distinguished  from  a  manufacturer's  revenue.  An  important  purpose  of 
accounting  is  to  show  different  kinds  or  sources  of  revenue. 

Theoretically  it  is  well  to  distinguish  between  the  pure  economic  rent  and  the 
return  for  capital  spent  on  improvements ;  but  in  practice  rent  is  usually  figured  as  a 
simple  percentage  on  the  value  of  the  real  estate. 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    279 

occupancy,  but  on  the  ratio  which  the  number  of  artificial  lights 
required  by  this  machine  bears  to  the  total  number  required  in  the 
factory). 

Some  persons  have  objected  to  charging  these  things  to  machine 
cost  on  the  ground  that  buildings,  Hght,  etc.,  are  provided  quite  as 
much  for  operatives  as  for  machines.  Labor  cost  is  recommended 
as  a  better  basis  for  distributing  this  burden.  The  matter  is  of  little 
consequence.  All  we  are  after  in  this  case  is  a  basis  for  distributing 
burden,  and  it  makes  little  difference  whether  we  use  labor  or  ma- 
chine cost.  As  a  matter  of  fact,  however,  light,  heat,  and  shelter 
cost  as  much  for  a  boy  working  at  fifty  cents  a  day  as  for  a  man 
working  at  five  dollars  a  day;  and  therefore  the  amount  of  wages 
is  not  so  good  a  basis  as  the  machine  requirement. 

Let  us  now  see  what  are  the  elements  of  the  second  group  of  ex- 
penses, which  we  have  called  machine  cost.  These  are  simply  the 
five  normal  elements  (named  above) :  interest,  on  the  value  of  the 
machine  itself ;  cost  of  repairs  due  to  passage  of  time  rather  than  to 
use  (for  the  latter  belongs  in  the  next  group) ;  depreciation  that 
repairs  cannot  prevent  (especially  obsolescence,  or  falling  behind 
the  times) ;  taxes  (this  machine's  proportion  of  the  total  taxes  upon 
machinery) ;  insurance  (this  machine's  proportion  of  the  total  in- 
surance on  machinery).  On  four  of  these  five  normal  elements  no 
comment  is  necessary ;  depreciation  will  be  considered  later  by  it- 
self. 

The  next  group  of  expenses  we  have  called  machine-use  cost. 
These  are:  first,  the  direct  expenses  of  operation,  such  as  for  oil, 
cleaning,  etc.  (but  not  power,  for  that  is  joint  and  hence  must  be 
figured  on  a  basis  of  its  own) ;  second,  repairs  due  to  wear  and 
tear;  third,  depreciation  (due  to  use)  that  repairs  cannot  over- 
come ;  fourth,  superintendence ;  fifth,  the  five  normal  elements  — 
interest,  repairs,  depreciation,  insurance,  and  taxes — on  any  special 
tools  which  may  be  required  in  connection  with  this  machine  but 
are  not  included  in  the  cost  of  the  machine  itself.  The  last  item 
is  included  here  because  the  tools,  always  kept  with  the  machine, 
would  not  be  included  in  the  valuation  of  tools  in  the  tool  room. 
When  the  machine  is  abandoned,  however,  they  become  free. 
Hence  they  belong  not  with  machine  cost,  but  with  machine-use 
cost.   The  superintendence  item  sometimes  could  be  more  wisely 


28o  ACCOUNTS 

put  elsewhere.  Our  purpose  is,  as  has  been  already  suggested,  to 
attach  as  many  as  possible  of  the  elements  of  burden  to  particular 
machines,  for  this  simplifies  our  task.  Superintendence  is  bound 
to  be  a  part  of  the  burden  in  any  case,  for  it  cannot  be  a  prime  cost. 
If,  then,  in  one  operating  room  with  a  dozen  machines  of  one  type, 
at  one  cost,  we  have  one  foreman  in  charge,  his  wages  may  be  debited 
directly  here  to  each  machine  as  one  twelfth  of  his  total  wages. 
When,  on  the  other  hand,  a  foreman  is  in  charge  of  a  room  contain- 
ing many  machines  of  different  types  and  of  different  costs,  it  would 
be  practically  impossible  to  say  what  proportion  should  be  charged 
to  each  machine.  Consequently,  our  item  of  superintendence  should 
or  should  not  be  included  here  according  to  circumstances.  If  not 
here  it  must  be  introduced  elsewhere  in  the  burden  to  be  distributed 
otherwise.  Often  it  would  not  be  worth  while  to  divide  repairs  and 
depreciation  between  machine  cost  and  machine-use  cost.  Since 
machines  often  become  obsolete  before  they  wear  out,  deprecia- 
tion could  be  charged  as  machine  cost  and  repairs  as  machine-use 
cost. 

Our  last  group  is  power  cost.  The  determination  of  the  proportion 
which  should  be  attached  to  each  machine  must  be  based  upon 
many  figures,  but  in  principle  it  is  very  simple.  The  power  estab- 
lishment is  itself  subject  to  three  of  the  four  groups  of  charges  that 
we  have  already  connected  with  the  other  machines,  that  is,  space  cost, 
machine  cost,  machine-use  cost ;  for  the  power  plant  is  responsible  for 
its  share  of  the  ground  rent  of  the  whole  establishment,  for  the  five 
normal  elements  upon  its  own  building,  for  its  light,  for  the  five  nor- 
mal elements  upon  its  own  machinery,  and  for  its  special  use  costs. 
These  would  be  figured  as  for  the  other  machinery ;  but  they  would 
include  a  greater  number  of  items,  —  that  is,  the  five  normal  ele- 
ments on  all  shafting,  belting,  pulleys,  and  other  things  used  in  the 
transmission  of  power  (other  than  those  things  already  included 
in  the  figures  for  specific  machines),  and  the  specific  cost  of  running 
the  power  plant,  as  fuel,  water,  wages  of  engineers  and  firemen,  and 
supplies.  These  figures  give  us  the  total  cost  of  supplying  power 
to  the  machine  shop.  The  cost  for  any  particular  machine  is  very 
clearly  its  proportion  of  power  consumption,  determined  by  the 
ratio  which  the  horse  power  required  by  it  bears  to  the  total  horse 
power  of  the  plant. 


PRINCIPLES  ILLUSTRATED  IN   FACTORY  ACCOUNTING     28 1 

This  completes,  roughly,  the  list  of  things  of  which  the  cost  can 
be  applied  directly  to  particular  machines.  These  four  groups  of 
cost  —  space  cost,  machine  cost,  machine-use  cost,  and  power  cost 
—  are  the  total  costs  of  running  the  machinery.  This  total  for  each 
machine  divided  by  the  number  of  working  hours  in  a  year  gives 
what  is  commonly  called  the  "  machine  hour-rate."  Some  allowance 
is  always  made,  of  course,  for  necessary  idleness  of  all  machines, 
such  as  for  repairs,  oiKng,  cleaning,  etc.  We  may  say  roughly,  for 
a  mere  working  hypothesis  here,  that  2700  hours  per  year,  9  hours 
per  day  for  300  days,  is  the  working  time.  Every  machine  in  the 
shop  has  its  symbol  or  number  and  has  attached  a  tag  giving  its 
hour-rate.  Since  all  work  performed  upon  it  is  done  by  the  authority 
of  a  job  order,  it  is  a  simple  thing  for  the  operator  when  reporting 
his  own  time  to  report  also  the  time  of  the  machine  which  he  has 
used.  This  gives  a  figure  of  machine  cost  to  be  debited  to  each  job 
order;  and  it  covers  all  the  burden  w^hich  we  have  been  able  to 
attach  to  the  use  of  machinery. 

This  all  may  be  illustrated  by  the  calculation  for  one  machine. 
An  important  fact  to  realize  is  that  after  this  has  been  done  for  one 
machine  little  labor  is  required  to  adjust  the  figures  to  the  needs 
of  another  machine,  for  many  of  the  calculations  are  of  universal 
application.  We  will  therefore  make  the  universal  calculations 
first  —  space  cost  and  power  cost. 

We  start  with  the  following  facts:  ground  rent  of  the  w^hole  es- 
tablishment, $1000;  valuation  of  shop  building,  above  the  ground, 
$15,000;  valuation  of  power  house,  $1500;  shop  share  of  groimd 
occupied,  f ;  power-house  share  of  ground  occupied,  |;  power-plant 
valuation,  $4000;  the  other  necessary  facts  are  sufficiently  ex- 
plained in  the  calculation  itself.  [See  page  282  for  the  figures.] 
These  totals,  $2250  for  space  cost  and  $4725  for  power,  are  ready 
for  use  with  any  machine  in  the  shop.  We  also  now  find  that  the 
total  heating  cost  is  $500,  of  which  f ,  or  $200,  is  chargeable  to  the 
shop,  and  the  total  Ugh  ting  cost  is  $420,  of  which  f,  or  $280,  is  a 
shop  charge. 

W^e  will  now  figure  the  share  of  these  items  belonging  to  machine 
#49,  and  add  the  costs  belonging  specifically  to  that  machine.  The 
prehminary  facts  are  these:  this  machine  occupies  2  017  of  the  floor 
space  of  the  shop,  takes  yJo  of  the  heat,  and  lio"  of  the  Ught;  its 


282 


ACCOUNTS 


Fundamental  Calculations 

Space  cost  —  Land  (Ground  rent  total,  $1000) 
Shop  proportion,  f 
Building  (Shop  valuation,  $15,000) 
Interest 
Repairs 
Depreciation 
Insurance 
Taxes 


Power  cost 


$400 

900 
100 

500 
150 

200 


Space  cost 


Machine  cost 


Use  cost 


Power  cost 

300  days  @  9  hours  =  2700  hours 

$204.16  -r-  2700  =  $.0756,  machine  hour  rate 


$2250 


Space  —  Land  (i  of  $1000) 

200 

Building  (Valuation,  $1500) 

Interest 

90 

Repairs 

10 

Depreciation 

50 

Insurance 

IS 

Taxes 

20 

Plant  (Valuation,  $4000) 

Interest 

240 

Repairs 

120 

Depreciation 

400 

Taxes 

60 

Insurance 

20 

Fuel 

1800 

Water 

100 

Wages 

1500 

Supplies 

100 

$4725 

Machine  No. 

49 

■zh^  of  $2250  Occupancy 

$11.25 

Tff(T  of      200  Heat 

2.00 

liu  of      280  Light 

2.00 

$15.25 

—  (Valuation,  $400) 

Interest 

24.00 

Care 

2.00 

Obsolescence 

20.00 

Taxes 

6.00 

Insurance 

4.00 

56.00 

Supplies 

3-25 

Repairs 

10.00 

Depreciation 

20.00 

Superintendence  (^^  of  $1000) 

50.00 

Special  tools  (Valuation,  $12.05) 

j 

20%  for  five  elements 

2.41 

85.66 

^h  of  $4725 

47-25 

$204.10 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     283 

valuation  is  $400;  it  is  in  a  room  with  19  other  machines  of  the 
same  type,  and  receives  -^-^  of  the  attention  of  a  superintendent 
paid  $1000  a  year;  in  connection  with  it  are  special  tools  valued  at 
$12.05,  but  as  such  tools  are  virtually  of  one  type  throughout  the 
shop,  a  single  rate  to  cover  the  live  elements  has  been  found  to  be 
20%  of  valuation;  it  consumes  yj^  of  the  power.  The  other  items 
are  self-explanatory.  If  printed  forms  are  used  only  little  labor  is 
required  to  find  the  rate  for  any  machine.    [See  page  282.] 

Our  determination  of  cost  in  connection  with  machinery  has  so 
far  been  on  the  assumption  that  all  machinery  is  driven  full  time. 
Theoretically,  no  machine  should  ever  lie  idle,  except  for  repairs, 
oiling,  cleaning,  etc.,  for  machines  should  be  put  into  a  shop  in  such 
proportion  that  they  shall  keep  each  other  busy  all  the  time.  Prac- 
tically, however,  this  is  impossible  except  for  shops  of  very  large 
size.  It  may  chance,  for  instance,  that  on  some  work  one  planer  can 
keep  up  with  three  drills,  and  that  on  other  work  one  drill  can  keep 
up  with  three  planers.  Indeed,  the  work  of  the  shop  may  be  con- 
stantly such  that  one  planer  can  keep  up  with  three  drills,  and  yet 
only  one  drill  is  needed  for  the  amount  of  business  done.  Since  it 
is  not  possible  to  economize  by  buying  planers  in  correct  proportion, 
that  is,  one  third  of  a  planer,  two  thirds  idle  time  on  that  machine 
must  be  constantly  suffered.  It  is  obvious,  then,  that  idle  time  is  so 
far  a  matter  of  importance  that  it  may  throw  entirely  out  of  useful- 
ness our  calculation  of  machine  rate  at  2700  hours  per  year,  and 
therefore  must  be  introduced  in  many  cases  as  a  new  element.  It  is 
deserving  of  careful  study. 

The  chances  of  unknown  waste  in  factory  administration  are 
alarming  and  the  purpose  of  cost  accounting  is  quite  as  much  to 
forestall  them  as  to  determine  actual  cost.  Four  classes  of  waste 
are  obvious,  —  in  material,  in  labor,  in  machinery  time,  and  in 
power.  Only  one  of  these,  in  material,  is  of  the  obvious  sort  that  can 
be  watched  by  mere  commonplace  methods.  The  stores  ledger  is 
one  means  of  accompHshing  this.  Whenever  for  an  hour  any  one 
of  the  other  three  expenditures  is  in  excess  of  what  can  be  utilized, 
loss  is  suffered;  and  the  arrangement  of  facilities  and  work  should 
be  such  that  each  is  available  in  exactly  the  strength  that  the  others 
can  use.  The  amount  of  power  needed  is  dependent  upon  the  num- 
ber and  kind  of  machines  in  use,  and  that  is  dependent  not  merely 


284  ACCOUNTS 

upon  the  kind  of  business  and  the  installation  of  machinery,  but 
upon  the  number  of  laborers  and  their  efficiency.  The  maximum 
utilized  power  which  should  be  a  factor  in  determining  our  machine 
rate  may  be  fixed,  then,  by  any  one  of  three  things,  and  which  of 
the  three  will  be  operative  will  depend  upon  circumstances.  Clearly, 
the  absolute  maximum  is  the  strength  of  the  power  plant.  Below 
that  may  be  the  maximum  consumption  of  power  by  the  machines 
installed.  Below  that,  again,  may  be  the  maximum  consumption  by 
the  machines  which  the  supply  of  labor  makes  it  possible  to  use. 
In  the  first  case,  the  engineer  develops  all  the  power  he  can  get.  In 
the  second  case,  he  should  develop  a  power  equal  only  to  the  known 
maximum  consumption  by  all  the  machines  installed.  In  the  third 
case,  he  should  develop  a  lower  power  indicated  to  him  by  the  su- 
perintendent on  the  basis  of  the  number  or  class  of  men  employed. 
In  calculating  our  machine  rate,  it  makes  a  great  difference  which 
of  these  three  maxima  of  power  we  use  as  the  total  of  the  shop. 
If,  for  example,  our  installation  of  machinery  could  use  150  horse 
power  and  the  total  capacity  of  the  power  plant  is  100,  we  are  com- 
mitting an  absurdity  if  we  fix  each  machine's  power  cost  at  its  pro- 
portion of  150,  for  150  is  never  produced.  In  such  a  case  100  must 
be  the  basis.  Clearly,  moreover,  not  all  machines  under  these  con- 
ditions can  have  full  use :  some  even  at  the  maximum  demand  must 
go  on  partial  idle  time.  Again,  though  the  power  be  200  and  the 
maximum  consumption  150,  if  labor  is  scarce  or  slow,  some  idle 
machine  time  must  be  suffered.  The  machine  rate  must  be  based 
not  on  an  arbitrary  figure,  but  on  the  total  power  actually  utilized. 
Experience  can  indicate  how  much  is  the  utilized  average  daily 
power  production  and  what  is  the  cost  —  remembering  that  the 
cost  does  not  vary  exactly  with  the  power  produced.  This  cost  and 
this  power  are  what  should  be  used  in  fixing  machine  rates,  for 
their  use  distributes  idle  power-capacity  to  machines,  and  thence 
to  jobs.  A  machine  consuming,  when  running,  twenty  horse  power 
in  a  plant  with  an  average  production  of  five  hundred  should  bear 
one  twenty-fifth  of  the  cost  of  power  for  its  running  time.  This 
leaves  no  power  undistributed.  Efficient  management  will  produce 
in  excess  of  the  power  needed  as  little  as  possible.  Then  so  far  as 
power  is  concerned,  the  idle  machines  are  negligible,  for,  since  we 
are  distributing  power  consumption  over  nmning  machines  and 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING      285 

not  over  all  machines,  the  transfer  of  one  machine  to  the  idle  class 
and  of  another  into  the  running  class  (a  shift  of  labor  and  of  power 
from  one  machine  to  the  other)  has  no  significance.  Some  precau- 
tions necessary  in  estimating  the  power  requirement  and  the  power 
cost  will  be  considered  later. 

Our  problem  now  is  the  proper  treatment  to  give  idle  machine 
time,  for  we  have  seen  this  to  be  common  and  even  unavoidable. 
The  answer  to  our  problem  may  depend  in  part  upon  the  condition 
of  competition.  Clearly,  if  the  small  plant  requiring  but  one  planer 
and  one  drill,  although  the  one  drill  might  as  well  serve  with  three 
planers  if  the  business  were  larger,  is  to  compete  on  even  terms  with 
a  large  plant  where  a  drill  is  run  full  time,  the  small  plant  is  wasting 
two  thirds  of  the  expense  of  this  drill,  and  cannot  charge  the  loss 
to  the  job  but  must  take  it  out  of  profits.  On  the  other  hand,  if  a 
shop  can  get  business  independent  of  competition,  because  of  the 
demand  for  such  a  shop  in  the  community,  it  may  both  properly  and 
practically  charge  to  the  job  loss  from  the  idleness  of  its  drill.  Here, 
then,  are  two  different  practical  treatments  of  cost  for  the  same  work, 
each  necessary  in  its  own  case.  In  one  case,  since  the  competing 
concern  can  do  the  work,  the  drill  in  the  small  shop  is  not  a  com- 
munity need,  but  simply  a  cost  of  getting  business  for  the  small  shop, 
and  idle  time  must  come  out  of  its  profits.  In  the  other  case,  since 
a  requirement  of  the  community  is  that  a  drill  be  maintained,  the 
jobs  needing  the  use  of  a  drill  must  pay  for  its  cost,  and  a  part  of 
that  cost  is  idle  time.  So  in  the  case  of  competition  the  machine 
rate  should  be  figured  on  the  basis  of  full  capacity,  say  2700  hours 
per  year ;  that  is,  the  total  cost  for  the  machine  must  be  divided  by 
2700  to  find  the  hour-rate,  for  the  competing  concern,  able  to  use 
its  drill  2700  hours  per  year,  includes  in  its  cost  a  rate  based  on  full 
time  and  the  competition  must  be  met.  In  the  non-competitive  case, 
however,  the  total  machine  cost  need  be  divided  by  only  900  to  find 
the  hour-rate  —  making  the  few  jobs  pay  for  idle  time. 

What  ought  the  books  to  show?  What  does  a  manager  wish  to 
know  about  this  matter  of  idle  time  ?  In  either  case,  competition  or 
quasi  monopoly,  it  is  desirable  that  the  idle  time  be  reduced  to  a  mini- 
mum. The  most  effective  stimulus  for  reducing  any  waste  is  to  show 
that  it  cost  something.  So  even  if  the  cost  of  idle  time  cannot  be 
charged  to  the  order,  good  accounting  demands  that  it  shall  be 


286  ACCOUNTS 

shown.  When  such  a  record  is  kept,  any  improvement  in  the  plan- 
ning of  work  or  in  the  size  of  the  business,  so  as  to  require  more  drill- 
ing, will  show  a  decreased  idle- time  account  and  consequent  in- 
creased profit.  If  the  books  failed  to  show  such  a  saving,  the  purpose 
of  accounting  would  so  far  fail.  Possibly  some  work  can  be  got,  to 
be  done  at  odd  times,  which  will  pay  for  the  otherwise  idle  time  of 
the  machines  and  meet  all  direct  costs,  though  not  contributing  any- 
thing to  the  general  burden.  Such  work  would  be  worth  while,  like 
some  railroad  traffic  discussed  in  Chapter  X.  It  could  not  be  safely 
taken,  however,  unless  the  cost  of  this  idle  time  were  known. 

Let  us  see  how  the  record  may  be  made  complete.  Every  job 
order  returned  shows  the  machine  rate  and  the  time,  as  we  have  al- 
ready seen.  The  only  machine  rate  we  have  so  far  figured  is  based  on 
full  time.  Now  we  have  seen  that  when  there  is  partial  time  there  may 
be  two  prices  for  the  same  work,  —  one  a  competitive  price,  based 
on  full  time  and  involving  loss  of  the  idle  time,  and  the  other  the 
quasi  monopoly  price,  based  on  partial  time  and  forcing  the  customer 
to  pay  for  idle  time.  The  actual  cost  is  the  same  in  either  case.  Some 
accountants  urge  that  the  machine  rate  be  figured  at  partial  time ; 
that  is,  if  the  probable  maximum  use  is  one  third,  the  machine  rate 
should  be  figured  as  if  900  hours  per  year  were  the  maximum  use 
for  the  machine.  This  charges  the  cost  of  idle  time  to  the  order, 
making  each  order  responsible  for  thrice  the  actual  time.  The  ob- 
jection to  this  is  that  in  the  competitive  market  prices  cannot  be  based 
on  the  cost  as  shown  by  the  books,  for  since  the  machine  cost  has 
been  figured  at  three  times  the  competitor's  figure,  by  so  much  the 
chance  of  getting  an  order  at  that  price  is  injured.  A  discount  must 
be  made  for  the  idle  time  that  competition  prevents  charging  to  the 
customer.  In  other  words,  though  the  cost  book  ought  to  be  the 
basis  for  making  prices,  it  has  been  kept  in  such  fashion  that  it  can- 
not be  used  in  competitive  conditions.  This  method,  moreover,  hides 
the  idle-time  cost  by  treating  it  as  if  it  were  full  time,  and  the  gain 
or  loss  of  altered  conditions  cannot  be  determined.  Other  account- 
ants urge  that  all  machine  rates  be  figured  on  a  full-time  basis  and 
idle  time  account  be  charged  for  waste.  The  objection  to  this  method 
is  that,  although  it  preserves  total  loss  on  the  books  and  is  so  far 
good,  enabling  one  to  discover  an  improvement  in  the  conditions, 
it  fails  to  show  the  actual  cost  of  work  on  the  partial- time  basis,  — 


PRINCIPLES  ILLUSTRATED  IN   FACTORY  ACCOUNTING     287 

a  cost  which  not  only  should  be  shown,  but  can  with  a  quasi  mo- 
nopoly be  put  upon  the  customer  to  pay.  As  a  matter  of  fact,  there  is 
no  reason  why  one  may  not  practice  both  methods,  with  little  more 
work  than  wath  either  alone,  and  get  the  advantages  of  both. 

Both  plans  mentioned  above  include  a  machine  ledger,  which 
has  a  space  for  each  machine  and  records  its  time  under  three  heads, 
occupied,  running,  and  idle.  It  is  noteworthy  that  a  machine  may 
be  occupied  on  a  job  when  not  running,  for  making  adjustments 
and  setting  up  work  preparatory  to  a  job  sometimes  takes  longer 
even  than  the  job  itself.  This  is  particularly  noticeable  in  the  case 
of  compHcated  patterns  of  cloth,  where  it  may  take  a  day  or  two  to 
set  the  machine  to  produce  cloth  which  will  be  completed  in  one 
day's  running  time.  It  is  clearly  necessary,  then,  under  any  plan, 
to  distinguish  between  occupancy  and  running  time,  for  a  job  must 
pay  for  occupancy  on  two  of  our  four  groups  of  cost,  that  is,  on  space 
cost  and  on  machine  cost,  but  it  need  pay  for  machine- use  cost  and 
power  cost  only  when  actually  running.  The  job  order  slips  will 
show  the  occupied  time  and  the  running  time.  The  idle  time  is,  of 
course,  simply  the  difference  between  the  occupied  time  and  the 
maximum,  and  need  not  be  figured  for  the  machine  ledger  day  by 
day,  but  only  at  convenient  intervals.  At  what  rates  shall  these  va- 
rious times  be  debited  to  the  orders  ?  We  can  get  all  the  information 
desired  with  but  three  figures  for  machines  not  driven  full  capacity. 
These  are  rate  not  running,  additional  rate  when  running,  and  the 
ratio  of  estimated  idle  time  to  occupied  time.  Occupancy  cost 
and  idle  cost  are,  of  course,  the  same;  that  is,  the  tw^o  elements  of 
space  cost  and  machine  cost.  Cost  when  running,  on  the  other  hand, 
is  greater  than  these  by  the  two  elements  of  machine-use  cost  and 
power  cost.  If  we  know,  in  addition,  the  ratio  of  idle  time  to  oc- 
cupied time,  we  can  distribute  idle  time  to  orders  at  will.  Whether 
the  condition  is  one  of  keen  competition  or  one  of  quasi  monopoly, 
a  job  actually  costs  idle  time  for  its  proportion  of  the  total  idle  time 
of  the  machine.  This  cost  should  appear  on  our  cost  book  in  a  way 
which  makes  it  easily  distinguishable,  —  so  that  we  may  omit  it  in 
estimating  prices  to  meet  competition  of  plants  running  full  time,  may 
include  it  where  the  demand  of  the  community  enables  us  to  charge 
the  idle  time  to  the  job,  and  may  know  in  either  case  how  much  could 
be  saved  by  conditions  that  would  prevent  idle  time.  Let  us  divide 


15-25 

56.00 

$71.25 

.0264 

85.66 

47-25 

132.91 

.0492 

288  ACCOUNTS 

the  common  machine  rate  into  two  rates,  minimum  rate  (rate  not 
running)  and  additional  rate  (extra  cost  of  running).  The  machine 
for  which  calculations  have  already  been  made  will  work  out  as 
follows:  - 

Space  cost 

Machine  cost 

Minimum  rate  =  $71.25  -^  2700  = 

Use  cost 

Power  cost 

Additional  rate  =  $132.91  -^  2700  =- 

$204.16        .0756 

This  does  not  require  a  separate  calculation,  for  it  would  be  made 
directly  on  the  original  sheet,  as  shown  on  page  282.  The  only 
change  required  is  provision  for  a  third  column  to  take  two-group 
totals,  as  above,  and  division  of  two  totals,  instead  of  one,  by  2700. 

The  calculation  of  the  actual  amount  to  be  charged  to  orders  for 
idle  time  is  interesting.  Suppose  this  machine  were  found  in  ex- 
perience to  be  idle  two-sevenths  of  the  time.  Then  each  order  is 
chargeable  for  its  share  of  idleness  in  that  ratio.  Since  a  machine 
is  not  idle  when  setting  up,  the  basis  for  figuring  the  fraction  of  idle- 
ness should  be  the  occupied  time,  which  is  known  for  each  order. 
If,  then,  the  machine  is  idle  two-sevenths  of  the  time,  it  is  occupied 
five-sevenths,  and  its  idleness  costs  two-fifths  as  much  as  its  occu- 
pancy. That  is  to  say,  as  we  already  have  the  cost  of  occupancy 
charged  to  the  order,  we  can  most  easily  charge  the  idleness  as  a 
ratio  of  the  amount  already  charged.  If  idleness  were  one-eighth, 
the  occupied  time  would  be  seven-eighths,  and  the  idleness  cost 
one-seventh  of  the  occupied  cost.  For  convenience  of  calculation, 
this  ratio  may  well  appear  on  the  machine  ledger. 

Occasionally  a  machine  is  idle  so  much  that  to  charge  idleness 
to  all  orders  using  the  machine  would  either  make  prices  prohibi- 
tive or  show  heavy  losses.  Some  managers  object  to  this,  and  there- 
fore object  to  any  treatment  of  idle  time  except  as  general  burden 
to  be  distributed  over  all  orders  whether  they  use  machines  com- 
monly idle  or  not.  The  fact  is  that  in  such  cases  machines  are  kept 
in  shops  not  primarily  for  manufacturing  but  for  advertising  or 
emergency  purposes.  The  shop  does  not  wish  to  reject  orders  in- 
volving such  work,  and  it  fears  that  such  work  cannot  always  be 
secured  outside  when  required.    So  it  maintains  the  machine  at 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING      289 

heavy  loss.  Accurate  cost  accounting  requires  that  even  in  such 
cases  the  cost  of  idle  time  be  charged  to  the  orders  using  the  ma- 
chines commonly  idle;  but  there  is  no  objection  later  to  transfer- 
ring some  or  all  of  the  cost  of  idleness,  as  circumstances  warrant, 
from  Manufacturing  to  Advertising,  or  to  Emergency  Insurance. 
Then  it  appears  where  it  is  primarily  desired,  in  the  cost  of  specific 
work  done  (but  so  shown  as  to  indicate  that  it  cannot  be  charged 
to  the  customer  and  was  transferred  from  Manufacturing),  and  in 
Advertising  or  Emergency  Insurance. 

Let  us  make  use  of  these  divided  rates.  Suppose  a  job  is  on  a 
machine  seven  hours  and  a  half,  of  which  one  hour  is  for  setting  up 
and  six  hours  and  a  half  is  running  time.  If  the  idleness  of  the  ma- 
chine is  two-thirds,  the  idleness  chargeable  will  be  twice  the  occu- 
pied time  —  for  two-thirds  is  twice  one-third.  Then  the  machine 
ledger  might  look  somewhat  as  follows,  omitting  items  not  service- 
able in  this  connection : 

Horse  power 

Idle  time  §  (May  i,  1908),  Ratio  2 
Machine  #  76  Minimum  rate  .0334 

Additional  rate  0431  (May  i,  1908) 

Date  [Occupied  timelRatejAmount  11  Idle  time  IRatel Amount  11  Running timej Add.  Rate! Amoudt 
Nov.  iSl  7  hr.  30  min.  I.0334I      .25       ||  i  hr.  30  miu.|.o334|      .05       ||  6  hr.  30  min.  |      .0431      |      .28 

We  may  now  carry  to  the  cost  book  the  figures  taken  from  the 
same  order  slips,  as  follows: 

Minimum  rate,  f  76,  7  h.  30  min.,  @  .0334  .25 

Idle  time,  twice  above  figure  .50 

Additional  rate,  6  h.  30  min.,  @  .0431  ^28 

1.03 

It  will  be  noted  that  though  on  the  machine  ledger  idle  time  was 
entered  at  $.05,  it  was  charged  on  the  order  at  $.50.  The  dis- 
crepancy is  due  to  the  fact  that  the  day  is  not  an  average  day.  To 
say  that  the  machine  is  idle  two  thirds  of  the  time  is  not  to  say  that 
it  is  idle  six  hours  each  day.  The  cost  of  idleness  must  be  distributed 
to  orders  not  according  to  the  actual  idleness  while  each  order  is  in 
progress,  but  on  the  basis  of  an  average  of  the  year. 

The  same  result  would  be  obtained  by  using  setting-up  time 
at  the  minimum  rate,  running  time  at  the  maximum  (minimum 
plus  additional)  rate,  and  idle  time  at  the  minimum  rate;  but 
this  would  disturb  some  ledger  figures  desired  later. 


290  ACCOUNTS 

^  Let  us  now  revert  to  a  few  elements  in  our  machine-rate  calcu- 
lation which  without  special  observation  may  fail  of  their  purpose 
and  leave  costs  unabsorbed  at  the  end  of  any  period. 

Repairs  may  not  follow  our  estimate,  but  it  should  be  noted  that 
we  are  concerned  not  with  actual  repairs  for  any  single  year  but 
with  repairs  distributed  over  the  life  of  a  property.  The  period 
of  distribution  is  one  of  great  importance  in  cost  accounting,  and 
yet  many  cost  accounting  schemes  have  neglected  it.  If  the  amount 
spent  for  repairs  on  a  machine  is  $ioo  in  one  year,  and  the  rimning 
hours  of  the  machine  for  that  year  are  2000,  is  the  repair  cost  $^ 
per  hour?  If  necessarily  so,  in  a  year  with  expenditure  of  $20  and 
hours  at  4000  the  cost  is  one-half  a  cent  per  hour.  Assuming  for 
the  moment  that  no  extraordinary  depreciation  occurs  from  over- 
working property,  the  cost  of  repairs  for  its  Hfe-time  is  a  charge 
against  all  its  product;  and  the  hour-rate  chargeable  for  repairs 
should  be  its  total  repair  bill  divided  by  its  working  hours.  It 
should  not  be  attached  to  product  more  heavily  in  one  year  than 
in  another.  This  means,  then,  that  from  experience  we  should 
estimate  the  total  repair  cost  of  a  piece  of  property  and  distribute 
that  as  an  hourly  charge,  based  on  the  expected  service  of  the  prop- 
erty, through  the  hourly  rates.  In  determining  the  charge  for 
building  repairs,  we  should  of  course  use  full  years.  For  machine 
repairs,  we  should  allow  for  expected  non-running  time  and  dis- 
tribute the  total  repair-cost  for  life  over  the  expected  running  hours 
for  life.  Then  our  additional  rate  will  absorb  all  repair  costs  unless 
our  expected  non-running  time  is  exceeded.  If  our  estimates  were 
correct,  this  would  be  the  perfect  method,  for  it  would  give  abso- 
lutely accurate  distribution  between  jobs.  Yet  even  with  fallible 
estimates  it  is  worth  attempting.  Joint  costs,  like  repairs  of  ma- 
chines, making  many  articles  of  product  scattered  over  many 
years,  absolutely  cannot  be  distributed  accurately  until  each 
machine  is  at  the  end  of  its  life;  but  cost  figures  and  price-making 
cannot  wait  for  that.  So  approximation  should  be  made  on  the 
best  information  and  judgment  available  as  the  machine  does  its 
work.  Discrepancies,  as  will  be  shown  later,  may  be  taken  up  and 
adjusted. 

Supplies,  as  an  element  of  use-cost,  will  not  get  absorbed  in  our 
charges  to  orders  unless  the  same  basis  is  used  for  figuring  as  for 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     29 1 

distributing  them.  If  they  are  put  into  the  rate  calculation  at 
what  the  machine  will  consume  in  a  year  on  its  estimated  partial 
time,  and  then  the  total,  as  in  the  calculation  above,  is  divided  by 
the  number  of  hours  in  full  time,  the  supplies  will  not  be  absorbed 
by  the  partial  time  actually  charged  to  orders.  Supplies  should  be 
put  into  the  calculation  as  for  a  year  of  full  running  time,  so  that 
the  proportional  amount  consumed  in  actual  running  time  will 
get  absorbed  by  charges  to  orders  for  that  running  time. 

Superintendence  cost,  so  far  as  it  is  attached  to  additional  rates, 
is  distributable  not  on  the  basis  of  the  machines  within  the  range 
of  supervision,  but  on  that  of  those  actually  under  supervision. 
If  a  room  has  twenty-five  machines,  but  only  twenty  are  normally 
run  at  a  time,  the  divisor  for  the  superintendence  cost  is  twenty 
rather  than  twenty-five.  Yet  if  the  charge  has  been  based  on  the 
supervision  of  twenty  machines  and  three  become  for  any  reason 
idle,  obviously  the  cost  for  the  remaining  seventeen  has  increased. 
The  extra  burden,  however,  is  not  chargeable  to  those  machines; 
for  the  tv/enty-five  are  supplied  with  joint  superintendence  for  their 
joint  benefit  at  the  time  of  greatest  need,  and,  except  so  far  as 
peculiar  circumstances  differentiate  the  machines,  the  cost  of  idle 
superintendence  is  a  joint  cost.  So  the  final  divisor  of  superinten- 
dence cost  for  each  machine  is  not  even  twenty,  if  the  average 
number  running  for  a  period  is  smaller,  but  that  smaller  number. 

The  same  sort  of  thing,  though  reversed  in  effect,  is  true  for 
charges  for  the  use  of  special  tools.  If  the  rate  charged  for  such 
tools  is  on  the  basis  of  an  annual  charge  and  yet  the  machine  rims 
less  than  full  hours,  the  charges  to  orders  for  actual  running  time 
will  not  distribute  the  annual  tool  charge.  So  far  as  these  tool 
charges  are  purely  time  charges  (interest,  taxes,  insurance,  obso- 
lescence) they  might  go  to  the  machine-cost  group  and  get  included 
in  minimum  rates;  but  so  far  as  they  include  depreciation  from 
wear  and  repair  cost,  they  belong  in  the  use-cost  group.  It  is 
likely  to  be  better  therefore  to  keep  them  in  the  latter  group.  Hence 
the  running  hours  of  the  machine  to  which  these  costs  are  attached 
must  absorb  thjem.  Since  the  cost  is  to  be  included  with  other  costs 
of  which  the  total  is  to  be  divided  by  the  full  number  of  hours  in  a 
working  year,  and  these  items  must  be  wholly  absorbed  by  a  part 
of  such  working  hours,  adjustment  is  easily  made  by  multiplying 


292  ACCOUNTS 

their  cost  by  the  reciprocal  of  the  fraction  representing  the  running 
time  of  the  machine  to  which  they  are  attached.  If  the  machine 
runs  three-fourths  of  the  time,  four-fourths  of  these  costs  must 
be  absorbed  by  three-fourths  of  the  full  running  hours  of  a  year;  and 
therefore  the  proper  result  will  be  obtained  if  four-thirds  of  these 
costs  are  included  in  the  total  cost  on  a  full-year  basis,  [f  X  I  =  i] 
This,  of  course,  is  not  a  matter  of  importance  in  itself,  for  the 
amounts  are  small,  but  it  illustrates  a  method  of  making  adjust- 
ments to  a  comprehensive  plan  and  thus  avoiding  the  annoyance 
and  labor  of  providing  for  exceptions. 

We  originally  carried  to  minimum  rates  (space  cost  and  machine 
cost)  all  items  of  joint  cost  that  are  governed  by  lapse  of  time,  and 
we  provided  Idle  Time  account  to  absorb  that  part  of  such  costs 
not  absorbed  in  occupancy  of  machines.  We  have  just  adjusted 
all  the  elements  of  use-cost  that  are  not  directly  governed  by  run- 
ning time.  If,  then,  we  can  adjust  our  figure  of  power  cost  to  the 
variations  of  power  demand,  we  shall  have  our  costs  accurate  as 
far  as  they  can  be  made  without  waiting  for  the  end  of  a  period. 
We  have  already  seen  that  attempt  is  made  to  regulate  power 
supply  by  power  demand,  and  that  presumably  one  machine  picks 
up  the  power  dropped  by  another.  This  is  an  adequate  assump- 
tion for  devising  our  system,  but  adjustment  is  likely  to  be  neces- 
sary for  the  stubbornness  of  facts. 

Power  cost  does  not  vary  exactly  with  power  production,  for 
some  elements  are  constant.  One  cannot  always  produce  more 
power  by  just  the  amount  of  horse-power  desired.  To  increase 
power  by  a  few  horse-power  may  mean  the  firing  of  another  boiler 
at  an  increased  cost  of  much  more  than  the  proportional  increase  in 
power;  and  a  reduction  in  power  may  make  it  possible  to  reduce 
cost  in  a  larger  or  smaller  degree.  The  estimate  of  power  cost,  then, 
is  likely  to  be  the  furthest  from  accuracy  of  all  our  estimates.  Idle 
machine  time,  as  we  have  seen,  costs  just  as  much  as  occupied 
time;  running  machine  costs,  on  the  other  hand,  vary  virtually 
exactly  with  the  running  time.  Our  power  cost,  however,  varies 
with  neither.  In  other  words,  it  partly  stops,  but  not  wholly,  with 
idleness;  and  it  partly  varies,  but  not  pari  passu,  with  running  time. 
The  most  convenient  handling  of  it  is  to  form  an  estimate,  based 
on  expected  factory  out-put  and  on  experience,  of  power  require- 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING    293 

ment  for  the  period,  with  an  estimate  of  power  cost  for  that  esti- 
mated production,  and  find  the  resulting  horse-power  hour-rate. 
Then  each  machine,  with  a  known  power  consumption  per  hour, 
can  be  charged  its  due  rate  for  its  actual  running  time  —  virtually 
as  by  the  proportional  charge  used  in  the  illustration  on  page  282. 
If  times  are  dull,  the  power  capacity  will  not  be  utiUzed  even 
normally,  and  the  estimated  requirement  of  power  will  be  accord- 
ingly low;  but  as  the  estimated  cost  will  not  be  necessarily  reduced 
in  the  same  proportion,  the  power  rate  will  be  higher.  This  vary- 
ing element  of  power  cost  is  not  a  weakness  in  the  system :  it  is  one 
of  the  virtues.  Cost  is  actually  high  in  seasons  of  much  idle  power- 
capacity,  just  as  it  is  high  in  seasons  of  much  idle  machine-capacity 

—  and  for  the  same  reasons.  Both  kinds  of  idleness  are  special 
factors  in  the  special  costs  of  a  slack  period,  and  hence  are  distin- 
guished from  those  general  factors  which  are  common  to  many 
periods  —  such  as  repairs  and  depreciation.  So  for  the  same  reason 
that  repairs  and  depreciation  should  be  distributed  over  all  periods, 
idleness  costs  should  be  concentrated  in  the  period  when  they  occur. 
Such  periods,  however,  should  not  be  shorter  than  a  normal  cycle 

—  from  the  time  of  normally  full  business  through  dull  business 
around  to  full  again.  To  use  a  rate  for  power  based  on  a  month 
which  is  at  either  end  of  the  scale  of  the  period's  activity  may  help 
to  guide  one  into  or  away  from  such  months  in  future,  but  it  does 
not  assist  much  in  finding  normal  costs;  for  power  capacity  is 
maintained  for  the  needs  of  a  cycle  as  a  whole,  and  its  cost  of  idle- 
ness is  a  part  of  the  cost  for  the  good  months  in  whose  interest  the 
burden  is  carried  in  slack  months. 

We  have  now  made  several  adjustments  in  our  machine  rate 
because  of  the  indirect  effect  of  machine  idleness.  Yet  none  of 
these  is  nearly  so  important  a  factor  in  costs  as  the  adjustment 
which  we  made,  in  the  Idle  Time  account,  for  the  direct  cost  of 
such  idleness.  The  latter  we  declined  to  distribute  as  a  general 
charge  over  machine  rates,  for  we  wish  to  watch  it  in  an  isolated 
account.  These  minor  adjustments,  however,  we  distribute  by 
absorption  in  the  general  rate.  This  apparent  inconsistency  of 
method  is  not  real,  for  the  cause  of  these  minor  increases  in  cost 
is  the  same  as  that  of  the  major,  and  since  the  effect  of  the  major 
is  already  recorded  in  a  special  account  we  have  a  sufficient  index 


294  ACCOUNTS 

for  judging  the  effect  of  the  mmor  without  the  complication  of 
keeping  them  separately. 

A  number  of  our  figures,  we  have  noted,  are  based,  from  experi- 
ence, on  rather  long-term,  estimates  —  idle  time,  repairs,  supplies 
for  machine  use,  power  requirement,  power  cost.  If  these  estimates 
prove  wrong,  the  costs  will  be  by  so  much  inaccurately  reported. 
Yet  all  these  costs  except  repairs  may  be  currently  watched  by 
statistics  of  idle  hours,  power  production,  power  consumption, 
fuel  consumption,  etc.  If  the  current  figures  discredit  the  esti- 
mates, the  rates  may  be  adjusted.  As  a  matter  of  fact,  all  calcula- 
tions for  rates  should  include  a  certain  margin  for  safety,  and  yet 
not  enough  to  mislead  the  price  makers  in  making  bids  in  a  com- 
petitive market.  If,  then,  it  is  found  that  current  figures  indicate 
a  need  of  change  in  additional  rates  and  in  idle  time,  these  may  be 
made  easily  at  once.  These  are  the  elements  that  ought  to  vary 
with  temporary  conditions,  whereas  the  minimum  rate  should  not. 
Care  should  be  taken,  however,  to  compare  current  figures  with 
the  estimated  figures  for  the  corresponding  weeks  or  months  of  the 
whole  period,  and  not  with  average  estimates;  for  possibly  the 
actual  variations  were  important  elements  in  the  estimates. 

The  same  principle  should  be  applied  to  the  correction  of  ad- 
ministrative and  selling  costs  as  discussed  later. 

We  may  now  observe  the  effect  of  these  entries.  It  is  desirable 
to  keep  ledger  accounts  to  represent  each  of  the  many  elements  of 
burden,  and  some  of  these  will  overlap,  for  we  wish  to  correlate  some 
individually  and  others  in  groups.  For  example,  we  wish  to  keep  an 
account  for  fuel  so  that  we  may  compare  different  years ;  but  we  also 
wish  to  keep  total  power  cost,  which  includes  fuel.  We  wish,  again, 
to  see  how  the  total  charges  through  the  year  to  Manufacturing  for 
machine-use  cost  and  for  power  cost  compare  at  the  end  of  the  year 
with  the  actual  expenditures  on  these  counts,  —  for  only  by  doing 
so  can  we  tell  whether  our  estimates  are  sufficiently  accurate ;  and 
yet  these  include  power,  which  in  turn  includes  fuel.  We  must 
arrange  our  accounts,  therefore,  so  that  we  may  use  several  sorts 
of  combinations.  It  is  not  necessary  here  to  cover  the  whole  field, 
but  the  principle  can  be  easily  illustrated  from  the  items  already 
used.  Let  us  see  what  ledger  accounts  are  affected  by  the  machine- 
ledger  entry  and  the  cost-book  entry  just  given.  We  have  used  three 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     295 

rates  for  machinery,  —  the  machine  rate  (including  all  costs  for  ma- 
chinery used  all  the  time),  the  minimum  rate  (non-running  cost  for 
machinery  idle  part  of  the  time),  and  the  additional  rate  (machine- 
use  cost  and  power  cost  for  machinery  idle  part  of  the  time).  It  is 
possible  to  carry  the  analysis  of  results  a  Httle  further  by  dividing 
the  machine  rate  for  machines  running  all  the  time,  as  well  as  for 
the  others,  into  minimum  rate  and  additional  rate.  Though  this 
makes  a  little  more  work  (two  rates  and  totals  daily  instead  of  one), 
it  enables  us  more  closely  to  compare  estimated  costs  through  the 
year  with  actual  expenditures  as  shown  at  the  end  of  the  year;  for 
we  have  two  groups  of  items  to  compare  instead  of  one,  and  hence 
a  discrepancy  can  be  more  easily  identified.  We  will  assume  here, 
then,  that  on  the  general  ledger  two  accounts  are  kept  to  represent 
all  charges  to  orders  on  account  of  machinery  burden  —  Minimum 
Rates  and  Additional  Rates.  The  entry  of  our  cost  book,  given 
above,  must  be  posted,  therefore,  either  through  the  journal  in  sum- 
maries or  direct  from  the  cost  book  in  totals,  so  as  to  result  as  fol- 
lows : 

Manufacturing  1.03. 

To  Minimum  Rates  .25 

Idle  Time  .50 

Additional  Rates  .28 

Such  treatment  shows  that  manufacturing  cost  is  responsible  for 
$1.02  conferred  by  the  three  credited  elements. 

These  elements,  in  their  turn,  must  be  debited  at  the  end  of  each 
year,  or  oftener,  for  the  cost  which  enabled  them  to  serve  Manu- 
facturing. Additional  Rates,  for  example,  will  be  debited  for  the 
various  items  of  machine- use  cost  and  power  cost,  such  as  oil  and 
fuel.  The  difference  between  the  debits  and  the  credits  shows  by 
how  much  the  distribution  of  burden  to  orders,  on  these  counts,  has 
failed  to  meet  actual  expenditure  or  has  exceeded  it.  Such  balance, 
which  should  be  small,  may  be  carried  to  Manufacturing,  —  or  to 
Burden  Adjustments,  which  should  be  ultimately  closed  into  Manu- 
facturing. This  Burden  Adjustments  will  roughly  indicate  what 
changes  to  make  for  the  new  year  in  the  specific  rates.  ^The  second 
of  these  three  credited  accounts.  Idle  Time,  presents  a  somewhat 
different  case.  No  direct  distinguishable  items  can  be  charged  to  it, 
for  its  expenses  are  exactly  the  same  as  those  of  Minimum  Rates,  — 


296  ACCOUNTS 

that  is,  space  cost  and  machine  cost.  Indeed,  if  all  such  costs  are 
debited  directly  to  Minimum  Rates,  and  then  that  account  is 
credited  by  the  allowance  for  idle  time,  the  exact  situation  will  be 
represented.  This  transfer  must  be  made  by  debiting  Idle  Time 
and  crediting  Minimum  Rates  not  for  the  amounts  charged  to  orders 
on  the  cost  book,  but  for  actual  idleness  shown  on  the  machine  ledger. 
Then,  since  the  debit  to  Idle  Time  will  show  cost  of  idleness  and 
the  credit  will  show  how  much  was  distributed  to  orders,  the  differ- 
ence will  show  how  accurate  was  the  estimate  of  idle  time  —  for  both 
were  figured  at  the  same  rate.  The  balance  may  be  transferred  to 
an  adjustment  account,  or  directly  to  Manufacturing.  The  account 
for  minimum  rates  will  then  bear  its  proper  charges,  and,  when 
credited  as  above  for  the  charges  to  orders,  the  balance  will  show 
how  correct  were  the  calculations  of  rate.  This  balance,  like  the 
balances  of  the  other  accounts,  will  be  closed  to  an  adjustment  ac- 
count, or  directly  to  Manufacturing. 

We  may  summarize  the  treatment  of  burden  up  to  this  point  as 
follows :  as  far  as  burden  may  be  attached  to  the  use  of  machinery, 
it  is  distributed  among  orders  on  a  carefully  apportioned  series  of 
rates,  —  for  occupied  time,  for  running  time,  and  for  idle  time ;  and 
at  the  end  of  the  year  the  actual  costs  are  compared  with  the  yield 
of  these  rates,  and  adjustments  are  made.  These  accounts  are  by 
this  process  closed  without  a  balance  at  the  end  of  the  year,  and  the 
total  expense  which  they  indicate  is  carried  to  Manufacturing,  where 
it  joins  the  prime  costs  of  labor  and  materials.  Everything  may  be 
carefully  watched. 

Before  going  on,  it  is  well  to  note  that  this  sort  of  plan  is  subject 
to  an  infinite  number  of  variations  without  interference  with  the 
principles.  For  example,  we  have  assumed  above  that  machine  rate 
is  divided  for  all  machines  into  two  parts.  When  that  is  not  done, 
Machine  Rates  would  be  credited  for  all  earnings  of  full-time  ma- 
chines, Minimum  Rates  and  Additional  Rates  for  partial-time  ma- 
chinery would  be  closed  into  Machine  Rates,  crediting  it  at  the  end 
of  the  year,  all  costs  connected  with  machinery  would  be  debited  to 
that  account,  and  actual  idle  time  would  be  credited  to  it.  Again, 
the  five  normal  elements  of  cost  on  tools  attached  to  machines  were 
included  above  in  machine-use  cost.  When,  however,  such  tools 
are  attached  to  particular  machines  rather  than  to  a  group  of  ma- 


PRINCIPLES  ILLUSTRATED   IN  FACTORY  ACCOUNTING    297 

chines,  they  would  lie  idle  when  the  machines  were  idle,  and  then 
their  cost  must  be  included  not  in  machine-use  cost,  but  in  machine 
cost.  No  plan  can  stand  alone :  the  best  must  be  adapted  to  circum- 
stances; and  adaptation  to  concrete  cases,  when  the  ground  is  once 
laid,  is  far  simpler  than  this  complicated  abstract  exposidon  can 
indicate. 

We  have  still  remaining  several  elements  of  manufacturing  bur- 
den not  connected  with  machinery:  such  as  freight,  cartage,  storage, 
etc.,  connected  with  materials;  superintendence,  etc.,  connected 
with  labor;  and  general  administration.  These  are  practically  all 
capable  of  distribution  on  a  percentage  plan;  an  exception,  if  any, 
is  in  freight  and  cartage,  for  these  are  for  various  classes  of  goods 
from  various  distances.  Usually  the  difference  in  rate  and  distance 
is  not  so  great  as  to  make  necessary  the  figuring  of  freight  and  cart- 
age on  each  particular  lot.  When  desirable,  however,  it  may  be 
entered  by  items  in  the  record  of  cost  on  the  stores  ledger  and  in  the 
total  of  stores  account  in  the  general  ledger.  Otherwise,  for  joint 
costs  on  material,  the  elements  are  as  follows: 

Freight 

Carting 

Storehouse  space  cost,  including  ground  rent  and  the  five  normal  elements 
on  the  building,  and  ground  rent  on  storage  yards 

Storehouse  wages 

Storehouse  suppHes  consumed,  such  as  cord  and  twine,  oil,  stationery 

The  five  normal  elements  (except  repairs)  on  the  average  stores  (and  this  can 
be  easily  determined  by  taking  as  a  basis  the  stores  limit  plus  a  certain  per- 
centage of  the  standard  order) 

The  total  of  this  list  gives  us  the  joint  stores  or  material  expenses, 
which  when  divided  by  the  total  stores  used  gives  the  percentage 
to  add  to  the  cost  of  material  for  each  order. 

The  expense  of  superintendence  may  be  distributed  on  a  similar 
plan,  as  a  certain  percentage  to  be  added  to  the  labor  cost  for  each 
order. 

General  expenses  of  administration  may  be  easily  divided  down 
through  the  various  departments  as  far  as  the  conditions  warrant. 
For  example,  in  some  departments  the  administration  expenses  are 
likely  to  be  a  heavy  percentage  of  the  output,  and  such  departments 


298 


ACCOUNTS 


should  suffer  correspondingly  heavy  charges.  In  any  case,  the  total 
administrative  expenses  for  the  department  should  be  divided  by  the 
other  expenses  for  the  department,  and  the  result,  which  is  the  per- 
centage that  administration  bears  to  other  expenses,  should  be  ap- 
plied to  the  expenses  of  each  individual  order  and  the  result  added 
as  one  of  its  costs.  These  charges  to  Manufacturing  may  be  credited 
to  Administration,  and  at  the  end  of  the  year  adjustment  may  be 
made  for  discrepancy  as  in  the  cases  mentioned  above.  Similarly, 
general  manufacturing  expenses  not  incidental  to  any  particular 
department,  such  as  interest  on  work  in  process  of  manufacture, 
and  a  part  (the  rest  to  be  borne  by  the  selling  establishment)  of  the 
wages  of  general  officers,  of  office  space  cost,  of  office  employees,  of 
office  supplies,  etc.,  would  be  determined  as  a  percentage  and  added 
to  each  order.  These  two  divisions  of  administrative  expense,  de- 
partmental and  general,  would  in  practice  be  combined.  For  ex- 
ample, if  such  general  expenses  are  3%  and  such  departmental 
expenses  are  for  Department  A  10%  and  for  Department  B  5%, 
the  cost  books  would  show  simply  13%  added  to  all  work  done  in 
Department  A  and  8%  to  all  work  done  in  Department  B. 

The  disposition  of  all  these  costs  on  the  general  books  is  similar 
to  that  of  the  costs  already  shown  in  connection  with  machinery: 
that  is,  each  account  representing  one  of  these  elements  of  burden 
is  closed  into  an  account  representing  the  group,  and  then  the  group 
account  is  closed  into  Manufacturing.  For  example.  Storehouse 
Wages  is  debited  to  Stores  Costs.  Stores  Costs  is  credited  and  Manu- 
facturing is  debited  for  the  amount  charged  to  individual  orders. 
The  balance  of  Stores  Costs  shows  how  much  is  the  inaccuracy  of 
the  calculation. 

We  may  now  arrange  our  costs  up  to  this  point  in  summary 
form. 


Prime  costs 


Burden 


Machinery  costs 


Secondary  costs 


Administration 


Stores 
Wages 

Minimum  rates 
Idle  time 
Additional  rates 
Stores  costs 
Superintendence 
Departmental  expenses 
General  expenses 


PRINCIPLES  ILLUSTRATED    IN   FACTORY  ACCOUNTING    299 

Now  let  us  note  how  simply  in  practice  these  items  may  be  applied 
to  each  order.  Our  rates  and  percentages,  it  will  be  remembered, 
are  general,  figured  once  for  all  or  annually  or  semi- occasionally. 
The  task  of  entering  indirect  costs  for  each  order  is  applying  known 
rates  and  percentages  to  specific  cases.  The  entries  for  cost  of  an 
individual  order,  then,  are  as  follows  (the  figures  used  are  arbitrary 
to  show  treatment  only) : 

Stores  (from  order  slips)  100 

Stores  costs  (%  of  above)  10    no 

Wages  (from  order  slips)  30 

Superintendence  (%  of  above)  i       31 

Minimum  rates  (from  order  slips)  5 

Idle  time                  "        "        "  7 

Additional  rates       "        "        "  10      22     163 

Department  and  general  expenses  (%  of  total  above)  2 

We  must  note,  too,  that  practically  all  these  costs  are  accurate 
within  certain  limits.  The  prime  costs  should  be  exact.  The  total 
of  the  joint  costs  may  be  ascertained  as  often  as  desired;  and  the 
only  thing  left  to  mere  estimate  is  the  proportionate  amount  of  such 
joint  costs  which  is  to  be  borne  by  each  order,  —  but  that  is  so  care- 
fully worked  out  that  the  approximation  to  exactness  is  sure  to  be 
very  close. 

Before  passing  on,  it  is  well  to  note  that  our  discussion  of  manu- 
facturing cost  has  not  included  quite  all  items.  Nothing  has  been 
said  of  standard  drawings,  standard  patterns,  standard  flasks,  cranes, 
general  tools,  or  a  thousand  and  one  miscellaneous  items.  These 
present  no  difficulty,  however ;  for  each,  in  its  own  circumstances, 
must  fall  in  with  some  part  of  the  plan  already  outlined  or  give  an 
additional  step  on  the  same  principles.  In  general  the  expense  for 
them  is  the  five  normal  elements  (figured,  except  for  repairs,  on  their 
cost),  and  this  can  easily  be  added  to  machinery  costs  or  to  secondary 
costs,  as  circumstances  may  warrant. 

We  may  now  turn  to  the  costs  of  selling.  It  has  already  been  sug- 
gested that  seUing  cost  and  manufacturing  cost  must  be  clearly  dis- 
tinguished, so  that  a  change  in  either  manufacturing  conditions 
or  sales  conditions  may  be  registered.    If  there  is  any  confusion  of 


300  ACCOUNTS 

manufacturing  and  selling  costs,  the  books  by  so  much  fail  to  show 
the  results  of  change. 

The  first  question  to  arise  is  whether  the  sales  division  shall  be 
debited  for  goods  at  the  cost  to  the  manufacturing  division,  or  at  a 
somewhat  larger  figure,  —  allowing  the  manufacturing  division  to 
claim  a  profit.  The  argument  for  allowing  profit  to  the  manufactur- 
ing division  is  that  since  better  economy  will  be  registered  in  a  greater 
amount  of  profit,  the  inducement  to  enforce  better  economy  will  be 
great.  There  are,  however,  but  two  methods  by  which  the  manu- 
facturing division  may  be  allowed  a  profit.  One  of  these  is  by  allow- 
ing as  profit  an  arbitrary  percentage  on  cost.  This  obviously  will 
not  register  economies,  for  the  cost  is  itself  the  basis  of  the  profit. 
The  other  of  these  methods  is  to  allow  to  the  manufacturing  division 
as  profit  any  amount  by  which  it  can  reduce  cost  below  an  arbitrary 
figure.  Under  this  plan  if  there  has  been  a  reduction  in  wages  or 
in  the  price  of  raw  material,  by  so  much  is  the  economy  shown  by 
the  figure  of  profit  misrepresented;  and,  therefore,  the  plan  fails 
in  its  specific  aim.  When  labor  or  raw  material  has  become  more 
expensive,  on  the  other  hand,  this  plan  seems  to  blame  the  manu- 
facturing management.  By  this  method,  moreover,  the  labor  of 
preserving  cost  has  been  largely  thrown  away,  for  it  assumes  as  cost 
for  seUing  purposes  a  figure  that  bears  no  relation  to  the  cost  books. 
The  only  possible  method  of  measuring  comparative  economy  is 
comparing  actual  costs  in  different  years,  allowing  for  difference  in 
effective  wages  and  raw  material.  This  the  comparative  cost  register 
and  the  ordinary  cost  books  make  possible.  Since  such  comparison 
is  possible  directly  from  the  books,  the  eft'ort  to  find  a  measure  of 
economy  in  the  profits  of  the  manufacturing  division  is  mere  wasted 
energy,  —  and  sometimes,  as  we  have  seen,  worse  than  that,  for  it 
may  misrepresent  the  facts.  Finally,  to  handicap  the  sales  division, 
by  charging  it  arbitrary  prices,  is  hardly  fair  in  competition  with 
other  estabhshments  where  this  is  not  the  practice.  The  conclusion 
is  that  the  selling  division  should  be  debited  for  all  goods  at  exact 
cost  to  the  manufacturing  division. 

Though  the  main  elements  of  selling  cost  are  obvious,  some  are 
likely  to  be  forgotten  without  special  attention.  First,  almost  all 
large  estabhshments  are  obliged  in  the  dull  seasons  to  accumulate 
stock  ready  for  the  demand  of  the  active  seasons.  We  have,  there- 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     301 

fore,  interest,  insurance,  depreciation,  and  taxes,  to  figure  on  this 
accumulated  stock.  This  is  not  exactly  manufacturing  cost,  for  the 
manufacturing  division  cannot  always  make  goods  at  the  variable 
rate  of  the  demands  of  the  seasons.  It  must  produce  them  when  it 
can.  It  is,  however,  the  task  of  the  selling  division  to  keep  goods 
moving  as  rapidly  as  possible,  and  to  find  such  inducements  as  may 
be  worth  while  to  get  them  out  of  the  warehouse  in  the  dull  season. 
The  most  effective  stimulus  to  the  selling  division  for  keeping  the 
warehouse  clear  is  to  debit  this  division  with  the  cost  of  accumulating 
the  stored  stock.  Though  this  may  sometimes  seem  a  hardship,  it  is 
unavoidable;  for  charging  to  manufacturing  would  to  some  extent 
nullify  the  careful  cost-keeping,  especially  in  the  matter  of  compara- 
tive costs.  Some  overlapping  of  function  is  bound  to  occur  between 
the  manufacturing  and  the  selling  division,  and  that  is  just  why 
need  exists  for  a  general  manager,  whose  expenses  are  divided  be- 
tween the  two  divisions.  It  is  the  manager's  task  to  determine  how 
far  it  is  cheaper  for  the  manufacturing  division  to  accommodate 
itself  to  the  varying  demands  of  the  seasons,  and  how  far  the  task  of 
accommodation  shall  be  laid  on  the  selling  division.  Whatever  cost 
of  this  sort  is  incurred,  however,  seems  properly  to  belong  to  the  sell- 
ing division. 

Another  selHng  cost  likely  to  be  forgotten  is  that  of  the  estimating 
department.  In  many  lines  of  activity  a  great  deal  of  money  is  spent 
in  submitting  estimates  and  proposals  for  work,  even  involving 
elaborate  specifications  and  plans,  but  resulting  in  no  business. 
This  is  as  much  a  part  of  selling  expense  as  are  the  expenses  of 
traveling  men,  and  should  be  kept  in  an  account  by  itself,  not 
chargeable  to  particular  jobs  but  to  selling  costs  in  general. 

Some  production,  of  course,  will  have  no  seUing  cost  to  follow. 
For  example,  we  saw  early  in  this  chapter  that  in  the  factory  which 
we  were  discussing  there  might  be  certain  orders  for  construction  of 
equipment  and  for  plant  repairs.  Since  these  were  for  internal  use 
they  were  independent  of  selling  costs,  and  must  be  omitted  in  the 
distribution  of  selling  costs  over  product. 

The  more  obvious  selling  costs  remaining  are :  sales  division  space 
cost,  —  that  is  to  say,  its  proportion  of  ground  rent,  the  five  normal 
elements  (which  we  have  followed  all  the  way  through),  with  heating 
and  lighting,  for  the  buildings  occupied  by  that  division ;  salaries  of 


302  ACCOUNTS 

the  officers ;  correspondence,  bookkeeping,  etc. ;  traveling  salesmen's 
salaries  and  expenses ;  and  advertising.  These  expenses  may,  how- 
ever, apply  sometimes  more  strictly  to  some  articles  than  to  others. 
For  example,  if  any  article  has  not  been  advertised  for  years  and 
continues  to  sell  on  its  reputation,  but  slight  advertising  expense 
should  be  charged  to  its  cost.  Perhaps  a  small  charge  of  the  adver- 
tising expense  should  be  borne  even  by  this  article,  for  the  general 
advertising  keeps  up  the  reputation  of  the  firm  and  therefore  this 
particular  article  receives  its  share  of  the  benefit.  If,  again,  some 
exhibition  is  given  at  a  fair  in  which  only  a  few  articles  are  shown, 
the  cost  of  that  exhibition  should  be  charged  chiefly  to  those  articles, 
—  not  ail,  however,  for,  as  in  the  case  above,  the  general  improved 
fame  of  the  business  has  probably  sold  other  articles.  It  is  worth 
while  to  note,  too,  that  some  advertising  costs  may  not  be  exhausted 
in  the  year  of  occurrence.  An  advertising  campaign  may  have  a 
duration  of  several  months  or  even  years,  and  at  its  close  a  large 
item  of  resource  may  remain  in  a  form  similar  to  "good  will."  Cer- 
tainly in  a  merger  this  would  have  to  be  acknowledged,  and  in  any 
case  it  may  be  counted  as  an  asset,  reducing  by  so  much  the  share 
of  advertising  borne  by  the  year  in  question. 

In  ultimate  allocation  of  selling  cost,  then,  certain  special  costs 
will  be  assigned  to  certain  classes  of  sales,  and  then  the  remaining 
selHng  costs  will  be  distributed  among  the  various  orders  on  a  per- 
centage basis.  Since  all  special  costs  attributed  to  one  class  of  arti- 
cles are  an  exemption  for  the  others,  the  special  costs  are  assigned 
first,  and  then  the  general  costs  distributed  to  all.  That  is  to  say,  the 
total  general  selling  cost  is  divided  by  the  total  manufacturing  cost, 
so  as  to  show  the  percentage.  This  is  then  distributed  among  the 
several  orders  or  kinds  of  production  on  a  basis  of  their  manufac- 
turing cost  as  previously  determined. 

We  have  finally,  then,  for  every  article  manufactured,  the  following 
summary : 

Prime  Cost 


Producing  Cost  ,  ^     , 

Burden 


Selling  Cost  {^^"'\ 

I  Crcneral 


I 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    303 

The  total  of  these  figures  gives  us  what  we  set  out  to  find,  —  cost 
of  making  and  selling,  a  cost  below  which  the  price  cannot  go  without 
causing  the  article  to  fail  to  bear  its  share  of  the  cost  of  running  the 
establishment.  Of  this  total  cost,  the  prime  cost  and  the  machine 
rates,  since  they  are  different  for  different  articles,  must  be  treated 
individually  and  will  usually  appear  on  the  principal  books ;  but  the 
percentages,  which  are  uniform  for  whole  classes  of  goods,  may  be 
applied  to  individual  orders  outside  the  principal  books.  Conse- 
quently the  full  detailed  costs  are  likely  to  appear  not  on  the  books 
proper,  but  on  cards  or  sheets,  arranged  for  ready  reference.  These 
may  be  either  in  a  summary  form,  like  that  last  given,  or,  preferably, 
in  a  form  like  that  on  page  299  with  selHng  costs  added. 

It  will  have  been  observed,  of  course,  that  not  all  kinds  of  manu- 
facturing are  susceptible  of  this  sort  of  complete  accounting.  The 
type  which  we  chose  for  illustration  was  simple,  that  is,  the  manu- 
facture of  goods  chiefly  on  orders  or  the  manufacture  of  certain 
standard  articles  of  various  kinds.  Consequently  the  cost  of  each 
step  in  the  manufacturing  process  could  be  traced,  because  prac- 
tically each  step  was  an  entity.  Where  small  articles  are  manu- 
factured in  large  quantities,  with  most  of  the  product  of  one  type, 
the  cost  is  to  far  greater  extent  joint  than  that  which  we  have  so  far 
discussed;  and,  by  so  much,  it  is  more  difficult  to  analyze.  Always, 
however,  cost  should  be  analyzed  as  far  down  as  the  method  of 
production  will  allow.  In  a  textile  mill,  for  example,  almost  all  cost  is 
joint,  because  many  machines  are  at  work  producing  the  same  sort 
of  thing,  and  it  is  impossible  to  trace  the  various  steps  in  the  process 
for  each  part  of  the  product.  If  careful  statistics  are  kept,  however, 
it  is  always  possible  to  determine  averages :  that  is  to  say,  the  records 
should  show  materials  consumed,  the  wages  paid,  and  the  product 
manufactured  in  each  department  of  the  business.  So  far  as  the 
thing  is  possible,  a  textile  manufacturer  should  determine  not  only 
the  average  cost  of  each  piece  of  goods  of  each  kind,  but  even  the 
average  cost  of  each  piece  of  goods  of  each  pattern.  There  is  a  limit, 
of  course,  beyond  which  this  thing  cannot  go ;  but  it  is  usually  sur- 
prising to  find  how  much  it  is  possible  to  save  at  a  little  expense  for 
accounting. 

Still  other  types  of  manufacturing  need  no  such  careful  account- 
ing as  that  outlined  here,  for  their  products  are  made  with  fewer 


3Q4  ACCOUNTS 

variations  in  the  elements  of  cost.  Shops  doing  only  hand  work, 
for  instance,  have  no  concern  with  machine  rate.  Of  those  items 
which  we  attached  to  machines  in  the  plan  discussed  above  they 
have  only  space  cost;  this  may  be  distributed  largely  on  the  basis 
of  bench  space,  but  if  little  variation  in  bench  space  occurs  it  can 
be  carried  as  a  part  of  general  burden.  If  in  a  shop  the  only  ma- 
chines used  are  employed  uniformly  for  all  product,  all  costs  con- 
nected with  them  may  also  be  included  in  general  burden.  If  all 
machines  are  of  about  the  same  value  and  have  about  the  same  rate 
of  depreciation  and  occupy  about  the  same  space,  even  though  some 
are  used  for  some  products  and  others  for  other  products,  a  machine 
rate  may  be  devised  common  to  them  all  and  used  for  all  jobs  irre- 
spective of  the  particular  machine  used.  If,  again,  in  such  a  shop 
all  product  is  machine  product  and  requires  virtually  the  same 
time,  all  machine  cost  is  uniform  and  hence  may  go  as  general 
burden. 

Obviously  much  labor  is  saved  by  treating  expenses  other  than 
machine  cost  as  general  burden,  for  then  one  calculation  furnishes 
the  basis  for  distribution  to  all  products;  but  saving  labor  in  this 
way  is  defensible  only  when  conditions  warrant  a  uniform  distri- 
bution of  burden  to  all  product.  There  may  be  many  bases  for  uni- 
form distribution  of  burden,  however.  Sometimes  absolute  uni- 
formity of  cost,  in  dollars  and  cents,  should  be  added  in  general 
burden  to  each  article  produced.  Sometimes  the  general  burden  is 
a  uniform  percentage  to  be  added  to  the  prime  cost.  Sometimes 
it  is  uniform  for  each  hour  of  labor  involved  in  the  article;  some- 
times for  each  dollar  of  wages. 

Many  factories  treat  all  burden  (or  "overhead,'^  as  it  is  often 
called),  whether  for  machine  cost,  superintendence,  or  miscellane- 
ous expenses,  as  general  burden  and  distribute  it  in  proportion 
to  the  number  of  hours  of  labor  involved  in  the  job ;  others  in 
proportion  to  the  amount  of  wages  paid;  others  as  a  percentage 
on  the  prime  cost.  Sometimes  one  of  these  is  scientific,  for  condi- 
tions are  just  right  for  it.  Commonly,  however,  a  little  analysis 
will  show  seriously  false  figures  of  cost  arising  from  any  such  blan- 
ket distribution.  If  hours  of  labor  are  used,  as  much  burden  is 
charged  for  the  production  of  an  article  made  of  cheap  material 
by  a  skilled  hand  operative  who  needs  no  watching  as  for  the  pro- 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    505 

duction  of  an  article  made  of  expensive  material  on  an  expensive 
machine,  with  much  consumption  of  power,  run  by  a  boy  who  needs 
constant  supervision;  and  yet  the  first  involves  little  burden  cost 
and  the  second  much.  Shifting  the  basis  of  distribution  to  wages 
paid  does  not  in  this  case  help  matters;  for  it  puts  even  more  on 
the  product  involving  Httle  general  expense.  The  percentage  basis 
may  be  in  one  respect  a  little  better,  for  the  stores-cost  burden 
attached  to  the  expensive  material  goes  where  it  should,  but  the 
machine  burden  is  charged  to  the  wrong  article  because  the  high 
wages  in  its  prime  cost  gives  it  a  high  percentage  of  burden  to 
carry.  None  of  these  plans,  then,  serves  in  a  shop  where  articles  are 
produced  under  such  different  conditions.  Yet  the  first  serves  where 
the  work  done  by  all  employees  involves  about  the  same  burden 
charges  —  as  space,  power,  superintendence,  storage,  etc.,  even 
though  the  rates  of  wages  are  different.  The  second  serves  where 
the  burden  involved  is  proportionate  to  wages,  as  when  it  chances 
that  low-price  labor  works  with  low-cost  material  on  low-cost  ma- 
chines with  little  superintendence,  but  high-price  labor  uses  high- 
cost  material  on  high-cost  machines  with  much  superintendence 
(assuming,  of  course,  that  high-cost  material  involves  high  stores 
charges,  as  it  often,  but  not  always,  does).  The  third  plan  serves 
even  though  low-price  labor  works  with  high-cost  material,  pro- 
vided the  burden  chargeable  to  material  is  not  only  proportional 
to  cost  of  material  but  bears  the  same  proportion  to  cost  of  mate- 
rial that  the  remaining  burden  (both  burden  for  machines  and  bur- 
den for  labor)  bears  to  cost  of  labor:  otherwise  an  article  costing 
four  dollars  for  labor  and  ten  dollars  for  material  would  receive  the 
same  burden  charge  as  one  costing  ten  dollars  for  labor  and  four 
dollars  for  material,  even  though  labor  burden  should  be  twenty 
per  cent,  and  material  burden  but  five.  The  cases  in  which  any 
of  these  plans  will  give  even  an  approximately  fair  distribution  of 
burden  are  few.  Modification  of  them,  however,  approaching  the 
plan  worked  out  above  in  detail,  may  fit  admirably.  In  other 
words,  a  plan  must  be  fitted  to  the  shop  to  which  it  will  apply;  and 
probably  no  plan  exactly  adapted  to  one  shop  wDl  ever  exactly  fit 
another. 

It  has  not  been  thought  worth  while  in  a  book  of  this  sort  to  deal 
with  the  details  of  keeping  the  subsidiary  records,  such  as  methods 


3o6  ACCOUNTS 

of  keeping  account  of  stores  on  hand  and  consumed,  labor,  time,  etc., 
for  these  things  are  necessarily  different  in  different  factories,  — 
not  only  because  of  the  varying  personalities  of  people  in  charge,  but 
because  of  the  varying  conditions  under  which  any  principles  must 
be  carried  out.  It  is  enough  here  to  indicate  the  principles  them- 
selves. 

We  are  now  concerned  with  the  matter  of  determining  profits. 
In  most  lines  of  business  an  account  of  stock  is  essential  to  any  de- 
termining of  profit,  but  here  we  have  been  singularly  fortunate  in 
being  able  to  identify  our  cost  with  our  product  at  every  step.  The 
manufacturing  account,  as  indicated  by  the  books,  includes  the  cost 
of  all  unfinished  as  well  as  finished  products  in  the  factory.  If,  then, 
whenever  any  goods  are  taken  from  the  shop  they  are  credited  to 
Manufacturing  and  debited  to  Stock  at  cost,  the  balance  of  Manu- 
facturing at  all  times  will  show  the  cost  of  unfinished  goods  in  the 
shop.  If  now,  when  goods  are  removed  from  the  warehouse  and 
shipped  from  the  establishment,  Stock  is  credited  at  cost,  Stock  can 
show  neither  profit  nor  loss,  because  debits  and  credits  are  at  the 
same  figure,  but  its  balance  will  show  always  the  cost  of  finished  goods 
on  hand  in  the  warehouse.  Finally,  if,  when  goods  are  shipped  and 
Stock  is  credited,  Sales,  or  Trading,  is  debited  for  cost,  as  has 
already  been  shown  advisable,  and  then,  when  buyers  are  debited  in 
the  sales  book.  Sales,  or  Trading,  is  credited  for  selling  price,  the 
balance  of  the  trading  account  indicates  gross  profit,  —  that  is,  the 
difference  between  manufacturing  cost  and  the  price  received.  If 
seUing  costs  are  then  debited  to  Sales,  the  balance  becomes  net 
profit. 

It  is  worth  while  to  note  how  complete  is  this  system  with  regard 
to  assets  in  the  form  of  material,  unfinished  work,  and  finished 
stock.  As  we  saw  long  ago,  the  balance  of  Stores,  both  in  the  stores 
ledger  and  in  the  general  ledger,  indicates  the  value  of  stores  on 
hand,  —  that  is,  it  is  a  pure  resource  account.  The  balance  of  Manu- 
facturing, again,  shows  the  cost  of  unfinished  work  on  hand,  and  is 
also  a  pure  resource  account.  The  balance  of  Stock  shows  the  cost 
of  finished  work  on  hand,  and  is  a  pure  resource  account.  The 
balance  of  Sales  shows  net  profit  on  goods  sold,  that  is,  it  is  a  nominal 
account  showing  profits,  —  the  resources  being  registered  in  cash, 
notes,  accounts  receivable,  etc.,  which  resulted  from  the  sales. 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    307 

It  will  be  observed  that  under  this  plan  no  profit  is  allowed  for 
unfinished  work  on  hand.  On  general  principles,  unfinished  work 
should  be  counted  as  an  asset  for  cost  only.  An  element  of  all  nat- 
ural contracts  is  a  certain  degree  of  risk,  and  that  risk  may  involve 
loss  at  almost  any  stage  of  the  proceeding.  Until  the  work  is  done 
and  accepted,  therefore,  the  profits  are  merely  on  paper.  The  work 
done,  however,  unless  already  costing  more  than  the  contract  price, 
is  a  full  asset,  for  it  will  count  toward  the  final  accomplishment  re- 
quired by  the  contract.  On  important  contracts  nearly  completed, 
when  large  profits  are  in  sight,  this  plan  seems  to  result  in  an  inac- 
curate distribution  of  profits  between  two  years;  and  it  would  cer- 
tainly be  unfair  if  a  partnership  that  had  conducted  the  work  were  to 
be  dissolved  just  before  completion  of  the  contract.  This  is  one  of 
the  cases  in  which  common  sense  is  a  better  accounting  principle 
than  any  rule  or  formula.  Similar  unusual  conditions  may  at  any 
time  lead  to  a  departure  from  general  principles.  Of  course  if  a  part 
of  the  work  is  known  to  be  wasted,  so  that  the  contract  will  result 
in  loss,  that  part  should  be  written  off. 

This  long  explanation  of  method  may  be  made  clearer  by  a  sum- 
mary of  the  ledger  as  it  would  stand  after  the  accounts  had  been 
closed.  No  attempt  is  made  in  the  summary  below  to  give  a  com- 
prehensive view ;  but  enough  is  shown  of  each  sort  of  account  to 
indicate  the  principle  not  only  of  the  detailed  cost-keeping  (except 
for  individual  orders),  but  also  of  the  combinations  into  groups,  the 
comparison  of  estimates  with  results,  and  the  final  disappearance 
of  all  but  leading  totals  for  the  income  sheet.  The  detailed  costs 
for  particular  orders,  it  will  be  remembered,  are  shown  on  the  special 
cost  books,  from  which  are  posted  (directly  or  indirectly)  the  credits 
to  Labor,  to  Stores,  to  Minimum  Rates,  to  Additional  Rates,  and  to 
Idle  Time,  with  the  corresponding  debits  to  Manufacturing  (or 
Plant  Repairs,  Building  Repairs,  etc.).  It  will  be  noted  that  some  of 
the  entries  here  shown  need  be  made  only  weekly,  and  many  are  re- 
quired only  at  long  intervals  (annually,  semiannually,  or  quarterly), 
and  therefore  the  method  is  not  so  burdensome  as  the  illustration 
may  suggest. 

The  figures  used  below  are  arbitrary  and  are  intended  merely  to 
show  the  relations  of  the  different  accounts ;  they  may  be  called  units, 
or  dollars,  or  thousands  of  dollars,  indifferently.  The  accounts  are 


308  ACCOUNTS 

arranged  in  the  order  in  which  they  can  probably  be  most  conve- 
niently closed.  The  closing  of  many  accounts  cannot  be  accomplished 
until  many  other  accounts  have  been  in  part  closed  into  them ;  and 
so  the  order  in  v^hich  the  accounts  are  closed  is  of  great  importance. 
For  example,  to  take  an  extreme  case,  since  Administration  must 
bear  a  portion  of  space  cost,  Space  Cost  must  be  closed  first;  but 
since  space  cost  is  dependent  in  part  on  building  repairs.  Building 
Repairs  must  be  closed  still  earlier;  theoretically,  too,  building  re- 
pairs should  bear  a  portion  of  administrative  expense ;  and  we  then 
have  a  vicious  circle,  each  depending  on  the  others.  As  a  matter  of 
fact,  however,  since  the  portion  of  administrative  expense  chargeable 
to  Building  Repairs  is  small,  it  may  be  disregarded  or  taken  arbi- 
trarily in  advance  of  the  closing  of  Administration. 


Cash 


Pay  Roll 

:2oo        Cartage 

5 

Building  Repairs 

20 

Stores 

5 

Superintendence 

20 

Plant  Repairs 

22 

Administration 

15 

Power 

25 

Manufacturing  * 

983 

Estimating 

5 

Selling 

100 

Freight 
Cash  75        Stores  75 

Cartage 
Pay  Roll  5        Stores  5 

Rent  ' 

Loss  and  Gain  200        Space  Cost  200 


PRINCIPLES  ILLUSTRATED   IN  FACTORY  ACCOUNTING    309 


Fuel 

Cash 

no 

Lighting 

5 

Heating 

xo 

Power 

_25 

no 

no 

Lighting 

Fuel 

5 

Space  Cost 

5 

Heating 

Fuel 

10 

Space  Cost 

xo 

= 

= 

Building 

Repairs 

Pay  Roll 

20 

Space  Cost 

50 

Stores 

25 

Superintendence 

4 

Administration 

I 

50 

50 

z^zz 

= 

Depreciation 

Buildings 

60 

Space  Cost 

55 

Machinery 

III 

Minimum  Rates 

105 

Power 

II 

171 

171 

Taxes 

Cash 

26 

Space  Cost 

10 

Minimum  Rates 

IS 

Power 

X 

26 

36 

= 

= 

Insurance 

Cash 

47 

Space  Cost 

30 

Minimum  Rates 

a5 

Power 

2 

47 

47 

3IO 

ACCOUNTS 

Space 

Cost 

Rent 

200 

Stores 

tS 

Lighting 

5 

Minimum  Rates 

27s 

Heating 

10 

Superintendence 

9 

Building  Repairs 

50 

Administration 

II 

Depreciation 

55 

Power 

15 

Taxes 

10 

Selling 

25 

Insurance 

20 

350 

350 

Stores  ^ 

Cash 

1000 

Building  Repairs 

25 

Pay  Roll 

5 

Plant  Repairs 

20 

Freight 

75 

Power 

5 

Cartage 

5 

Manufacturing  ^ 

1050 

Space  Cost 

15 

1 100 

HOC 

Interest 

Loss  and  Gain 

3^5 

Minimum  Rates 

300 

Power 

15 

315 

315 

Superintendence 

Pay  Roll 

20 

Building  Repairs 

4 

Space  Cost 

9 

Minimum  Rates 

5 

Plant  Repairs 

5 

Additional  Rates 

IS 

29 

29 

= 

— 

Minimum  Rates 

Depreciation 

105 

Idle  Time 

125 

Taxes 

15 

Manufacturing  * 

598 

Insurance 

25 

Burden  Adjustments  * 

a 

Space  Cost 

275 

Interest 

300 

Superintendence 

5 

725 

725 

PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    311 


Pay  Roll 
Stores 

Superintendence 
Administration 


Cash 


r 


Plant 

Repairs 

22 

Power 

20 

Additional  Rates 

5 

_3 

50 

Oil 

5 

Power 

Additional  Rates 

General  Expenses  ' 


9 
48 


50 


Cash 


30 


Administration 


30 


Administration 

Pay  Roll 

15 

Building  Repairs 

I 

Space  Cost 

II 

Plant  Repairs 

3 

General  Expenses 

30 

Power 

I 

Manufacturing 

40 

Selling 

II 

i? 

56 

Power 

Pay  Roll 

25 

Additional  Rates 

175 

Fuel 

95 

Depreciation 

II 

Taxes 

I 

Insurance 

2 

Space  Cost 

IS 

Stores 

5 

Interest 

15 

Plant  Repairs 

2 

Oil 

3 

Administration 

I 

ITS 

175 

312 

ACCOUNTS 
Additional  Rates 

Superintendence 

15        Manufacturing  * 

«43 

Plant  Repairs 

48 

Oil 

2 

Power 

175 

Burden  Adjustments  * 

3 

243 

243 

Idle  Time 

Minimum  Rates 

125        Manufacturing  * 

123 

Burden  Adjustments  * 

2 

125 

125 

Pay  Roll 

983       Stock 

3»03S 

Stores 

1,050 

Minimum  Rates 

598 

Administration 

40 

Additional  Rates 

243 

Idle  Time 

123 

Burden  Adjustments 

I 

3.038 

3,038 

Burden  Adjustments 

Minimum  Rates 

2        Additional  Rates 

3 

Idle  Time 

2        Manufacturing  * 

I 

4 

4 

— 

= 

Stock 

Manufacturing 

3,038       Sales 
Advertising 

3,038 

Cash 

200        Selling 
Estimating 

200 

Pay  Roll  • 

5        Selling 

5 

PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING 


313 


Pay  Roll  • 

Space  Cost 
Administration 
Advertising 
Estimating 


Selling 

100        Sales 

25 
II 

200 
_5 
341 


341 


341 


Stock 

Selling 

Loss  and  Gain 


Balance 


Sales 

3,038       Cash 

341 

liL 
3>5io 

Loss  AND  Gain 

^4^        Rent 

Interest 
Sales 

Balance 


3»5io 


3.510 


200 

315 

ill 
646 


*  These  debits  to  Manufacturing  and  credits  to  these  accounts  are  posted  from  the 
totals  of  the  charges  to  individual  orders. 

^  This  is  on  the  supposition  that  the  real  estate  is  ov^^ned  by  the  concern.  If  not,  the 
only  difference  is  that  another  entry  will  debit  Rent  and  credit  Cash,  and  then,  since 
Rent  is  closed,  no  item  of  rent  will  go  to  Loss  and  Gain  as  an  earning. 

'  Stores  Costs  is  here,  for  brevity,  consolidated  with  Stores. 

*  These  adjust  the  discrepancies  between  the  charges  to  orders,  based  on  estimates 
for  joint  costs,  and  the  actual  costs  found  at  the  end  of  the  year  or  other  settling  day. 
In  two  of  these  cases,  Burden  Adjustments  shows  that  the  charges  to  orders  were  a 
trifle  less  than  the  actual  burden;  in  one  case  it  shows  excess. 

*  This  account  suggests  the  condensed  nature  of  some  of  the  items  shown  here. 
Properly  this  account  should  be  cut  up  into  several,  as  Stationery,  Postage,  Tele- 
graphing, etc.  Stationery,  moreover,  should  be  closed  not  only  into  Administration, 
as  here,  but  also  in  part  into  Stores,  Superintendence,  etc. 

'  It  will  be  noted  that  both  Estimating  and  Selling  are  debited  by  Pay  Roll,  and  yet 
Estimating  is  ultimately  closed  into  Selling.  A  short  cut  would  be  to  close  Estimating 
into  Selling  first,  and  then  to  debit  Selling  by  Pay  Roll.  This  would  not  be  good  ac- 
counting, however,  for,  since  the  wages  of  estimating  would  be  combined  with  the 
other  wages  of  selling,  it  would  not  show  anywhere  the  actual  costs  of  the  estimating 
department. 


L 


314  ACCOUNTS 

In  interpreting  these  entries  we  must  note  that  virtually  three 
classes  of  accounts  are  kept  —  primary,  intermediate  or  group, 
and  ultimate.  The  primary  accounts  are  for  first  costs  —  for  ex- 
penses incurred  in  obtaining  something  from  outside  of  the  estab- 
lishment. Such  are  Pay  Roll  (for  though  the  employees  and  ofl&cers 
work  in  the  estabhshment  they  are  paid  for  their  services  and 
hence  are  from  that  point  of  view  outside  of  it),  Freight,  Fuel, 
Taxes,  and  Insurance.  The  ultimate  accounts  give  the  final  figures 
desired,  as  Manufacturing  and  Selling.  The  intermediate  or  group 
accoimts  serve  to  show  functions  rather  than  objects  of  expense 
and  to  consolidate  various  primary  accounts  into  large  or  small 
groups,  sometimes  to  recombine  groups  into  larger  groups  ready 
for  transfer  to  ultimate  accounts.  These  are  commonly  called 
"clearing  accounts."  Such  are  Building  Repairs,  Space  Cost  (which 
combines  Building  Repairs  with  other  things),  Minimum  Rates, 
and  Power.  Sometimes  several  group  accounts  stand  between  the 
primary  and  the  ultimate,  as  Plant  Repairs,  Power,  and  Additional 
Rates,  between  Pay  Roll  and  Manufacturing  —  the  wages  being 
one  element  of  plant  repairs,  the  latter  an  element  of  power  cost, 
the  last  an  element  of  additional  rates  (for  running  cost  of  machines) 
which  is  a  large  factor  in  manufacturing  cost. 

Some  of  these  accounts  are  worth  study  in  detail,  for  only  with 
such  study  can  we  appreciate  the  interlocking  of  the  parts  and  yet 
the  completeness  of  detail.  The  credits  to  Pay  Roll,  for  example, 
are  obvious,  for  in  this  case  the  account  is  credited  for  work  done 
(charged  to  various  departments  or  functions)  and  debited  for  the 
cash  paid.  A  glance  at  the  ledger  for  the  accounts  named  on  the 
credit  side  of  Pay  Roll  will  show  that  each  is  debited,  with  Pay 
Roll  as  explanation.  Plant  Repairs,  for  instance,  has  its  charge  for 
pay  roll,  but  is  also  debited  by  transfers  from  Stores,  Superintend- 
ence, and  Administration.  These  debits  to  Plant  Repairs  are  then 
divided  between  power  machinery  and  shop  machinery,  and  the  ac- 
count is  closed  by  transfer  to  Power  and  Additional  Rates.  Power, 
in  turn,  is  debited  also  for  a  large  number  of  items  of  cost  trans- 
ferred thence  from  other  intermediate  and  primary  accounts,  — 
e.g.,  Pay  Roll  (going  direct  to  Power,  whereas  we  already  are  carry- 
ing along  some  pay  roll  that  went  to  Plant  Repairs  and  thence  to 
Power)  and  Fuel  as  primary  accounts,  and  Stores  and  Administra- 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     315 

tion  as  group  accounts.  These  last  two,  it  is  to  be  observed,  are 
also  debited  for  pay  roll,  and  thus  we  have  four  elements  of  wages 
in  Power;  but  that  is  just  what  we  desire,  so  that  we  can  know  not 
only  the  total  direct  wages  for  power,  but  also  the  wages  and  the 
total  cost  for  other  groups  that  lead  up  to  Power  and  to  still  larger 
groups.  The  total  of  Power  is  next  transferred  to  Additional  Rates, 
where  it  comes  into  union  with  Superintendence,  which  also  in- 
cludes pay  roll,  with  the  rest  of  Plant  Repairs  (all  that  was  not 
transferred  to  Power),  and  with  a  part  of  Oil  (the  rest  of  which  is 
included  in  Power) .  So  though  a  part  of  the  pay  roll  gets  into  Addi- 
tional Rates  with  only  one  intermediate  step  (Superintendence), 
a  part  is  carried  through  Plant  Repairs,  and  thence  through  Power; 
and  though  a  part  of  Oil  and  of  Plant  Repairs  goes  direct  to  Addi- 
tional Rates,  another  part  of  each  goes  through  Power,  from  which 
it  joins  the  first  part.  Thus  we  get  full  details  along  the  way,  avail- 
able for  guidance  in  eliminating  waste  and  in  making  estimates  of 
cost,  and  yet  we  get  our  final  figures  in  desired  totals,  for  Additional 
Rates  is  now,  with  other  elements,  closed  to  our  ultimate  account, 
Manufacturing. 

The  ledger  shown  above  is  not  complete,  nor  is  the  closing  meant 
to  indicate  always  the  best  way  of  closing.  Here,  for  example,  to 
simplify  the  illustration  and  save  space.  Depreciation  is  carried  to 
Minimum  Rates,  and  Plant  Repairs  to  Additional  Rates.  Each 
should  be  divided  between  them.  Fuel  is  closed  to  Lighting,  Heat- 
ing, and  Power.  This  is  a  short  cut  not  justified  on  theoretical 
grounds,  for  it  carries  to  Lighting  and  to  Heating  only  the  fuel  cost 
from  among  the  large  number  of  costs  making  up  Power.  If  the 
amount  is  correct,  it  may  be  said,  what  does  it  matter?  That  is, 
if  the  charge  to  Lighting  and  to  Heating  for  fuel  is  enough  in  excess 
of  their  shares  of  fuel  to  offset  the  neglected  share  of  other  power 
expenses  chargeable  to  them,  why  is  there  inaccuracy?  Two  un- 
fortunate results  follow:  first.  Lighting  and  Heating  appear  not 
to  be  charged  for  their  full  quotas  of  power,  and  a  correction  entry 
may  be  made  later  erroneously;  secondly,  the  overcharge  made  to 
these  accounts  for  fuel  (to  offset  the  undercharge  for  other  power 
expenses)  leaves  too  little  fuel  charged  as  an  element  of  power  cost, 
and  if  attempt  is  made  later  to  make  comparisons  with  other  years 
or  other  plants  or  other  power  systems  the  figures  may  mislead. 


3l6  ACCOUNTS 

For  the  sake  of  making  these  entries  balance,  we  may  show  also 
the  following  items  of  resource  accounts,  complements  of  those 
given  above. 

Cash 
Sundries  3)5io        Sundries  2,693 

Balance  817 


3»5io  3»5io 


Balance  817 

Buildings 

Depreciation  60 

MACfflNERY 

Depreciation  11 1 

A  trial  balance  taken  of  these  items  after  the  books  are  closed 
shows  the  following  interesting  figures,  and  no  others,  for  all  other 
accounts  are  balanced ; 

Loss  and  Gain  646 

Cash  817 

Machinery  1 1 1 

Buildings  60 

817        817 

The  credits  to  Machinery  and  Buildings  are  of  course  mere  de- 
preciation items  to  be  added  to  the  other  items  standing  to  those 
accounts,  that  is,  to  reduce  the  debit  balance  and  show  a  reduced 
valuation.  If  the  figures  of  the  trial  balance  above  are  taken  to 
represent  thousands  of  dollars,  the  profits  are  $646,000,  and  the  in- 
crease of  $817,000  in  cash  from  the  year's  business  is  derived  chiefly 
from  the  profits,  but  in  part  from  the  wearing  out  of  machinery  and 
buildings  converted  during  the  process  into  goods  which  are  later 
sold  for  cash.  This  sum  of  $171,000  from  depreciation  is  available 
for  replacement  or  a  replacement  fund,  but  of  course  it  is  not  avail- 
able for  dividends,  for  the  books  show  that  the  profit  is  but  $646,000. 

In  spite  of  the  brevity  of  the  final  result,  as  shown  in  the  trial 
balance  above,  the  details  are  preserved  all  along  the  line  and  can 
be  reported  as  fully  as  any  one  may  desire. 

It  is  obvious  that  in  factory  accounting,  as  well  as  in  other  kinds, 
statistics  are  important.  We  have  already  seen  the  need  for  many 


PRINCIPLES  ILLUSTRATED   IN   FACTORY  ACCOUNTING    317 

such  figures  in  our  determination  of  machine  rates.  The  general 
subject  of  statistical  accounting  has  been  illustrated  in  Chapter  XI. 
It  is  enough  to  note  here  that  the  field  for  serviceable  figures  of  this 
sort  is  very  large.  For  example,  from  the  available  statistics  on  our 
job  order  slips,  charts  can  be  prepared  showing  numerous  ratios 
which  the  manager  may  find  desirable  to  watch,  — such  as  the  ratio 
of  product  to  the  number  of  men  employed,  product  to  power  con- 
sumed, power  consumed  to  number  of  men  employed,  product  to 
material  used,  power  produced  to  fuel  consumed,  fuel  cost  to  labor 
cost. 

We  may  now  turn  to  the  question  of  factory  depreciation,  a  sub- 
ject which  has  been  left  for  comprehensive  treatment  by  itself.  This 
question  of  depreciation  in  factories  is  quite  as  serious  as  on  rail- 
roads and  is  more  complicated.  A  railroad  of  considerable  size 
suffers  depreciation  all  the  time  for  many  kinds  of  property  on 
different  parts  of  the  line  under  different  conditions  of  wear  and 
influences  of  cHmate.  It  is  unlikely  that  on  a  raihroad  the  number  of 
engines  giving  out  entirely,  so  that  they  are  better  fit  for  the  scrap 
heap  than  for  the  repair  shop,  will  be  much  greater  in  1908  than  in 
1907,  for  on  most  important  roads  the  number  of  engines  is  so 
great  that  a  fair  proportion  will  need  replacement  each  year:  the 
conditions  of  service  will  vary  so  greatly  that  not  all  engines  bought 
at  one  time  will  require  replacement  at  one  time.  So,  as  we  have 
already  seen,  Maintenance  of  Way  and  Structures  and  Maintenance 
of  Equipment  will  serve  as  a  fair  measure  of  depreciation  under 
normal  conditions,  though  it  is  true  that  many  railroads  maintain 
special  depreciation  funds.  In  most  lines  of  manufacturing,  how- 
ever, a  similar  condition  is  not  true.  Of  course,  much  of  the  wear 
and  tear  in  factories  can  be  made  good  by  ordinary  repairs,  such  as 
replacing  a  worn  cogwheel  with  a  new  one,  a  worn  belt  with  a  new 
one,  replacing  a  chimney,  or  what  not ;  but  when  it  comes  to  the  end 
of  such  repairs,  to  the  time  when  further  repairs  on  the  old  machines 
is  bad  economy,  we  are  likely  to  find  that  repairs  do  not  divide  main- 
tenance properly  between  different  years.  For  example,  a  cotton- 
mill  is  likely  to  equip  a  picker-room  or  a  weaving-room  complete  at 
one  time.  It  is  indeed  likely  to  equip  many  rooms  at  one  time.  The 
consequence  is  that  repairs  for  a  few  years  may  have  been  $1000, 
and  then  when  replacement  of  looms  in  the  weaving-room  becomes 


3l8  ACCOUNTS 

necessary  an  immediate  expense  of  $50,000  must  be  faced.  Next 
year  repairs  may  fall  to  $2000,  and  the  year  following  jump  to 
$25,000.  Under  such  conditions  ordinary  maintenance  is  no  criterion 
for  depreciation.  Depreciation  must  be  figured  theoretically  each 
year,  and  in  manufacturing  it  must  be  figured  by  methods  much 
more  elaborate  than  in  ordinary  mercantile  business.  In  the  case  of 
merchandise  a  fairly  uniform  rate  pertains  to  any  particular  line, 
but  in  factories  many  rates  are  operative  at  once.  Some  buildings 
of  a  factory  may  depreciate  at  less  than  2%  per  year  —  for  exam- 
ple, a  stone  warehouse  or  boiler  house,  —  while  others  —  for  example, 
a  wooden  foundry  —  may  depreciate  at  more  than  three  times  as 
much,  the  rate  being  influenced  by  heat,  smoke,  steam,  gas,  etc. 
Buildings  housing  heavy  shafting  which  revolves  at  high  speed,  and 
containing  machinery  operating  with  much  jar,  depreciate  with 
comparative  rapidity.  Machines  depreciate  more  rapidly  than 
buildings,  and  some  machines  more  rapidly  than  others.  Tools, 
again,  depreciate  more  rapidly  than  machines.  The  depreciation  of 
these  things,  moreover,  varies  in  different  degrees  with  respect  to 
time  and  kind  of  use.  Buildings  will  depreciate  perceptibly  with 
mere  lapse  of  time;  machines,  if  unused  and  well  cared  for,  less 
rapidly ;  and  tools,  if  unused  and  well  cared  for,  hardly  at  all.  De- 
preciation on  an  idle  machine  shop,  then,  is  comprised  of  at  least 
three  items,  the  effect  of  time  on  buildings,  on  plant,  and  on  tools. 
Depreciation  on  a  running  machine  shop  is  comprised  of  six  items 
at  least,  the  effect  of  time  and  of  use  on  buildings,  on  machines,  and 
on  tools.  If  a  shop  is  run  much  overtime,  a  new  set  of  causes  comes 
into  play.  A  machine  shop  run  night  and  day  will  suffer  depre- 
ciation made  up  of  at  least  eight  items,  —  from  time,  use,  and  abuse 
for  the  buildings,  from  time,  use,  and  abuse  for  the  machinery,  and 
from  time  and  use  for  the  tools  —  tools  being  practically  never 
used  incessantly.  It  is  on  these  considerations  that  the  amount  of 
depreciation  should  be  determined  as  an  element  in  the  machine 
rate. 

One  other  feature  of  factory  depreciation  is  essential  for  an  ac- 
countant. The  invention  of  new  machinery  may  render  old  ma- 
chinery useless,  —  so  far  at  least  as  goods  made  on  the  old  cannot 
compete  with  goods  made  on  the  new.  Machinery  is  perhaps  as 
often  put  out  of  use  by  obsolescence  as  by  wear  and  tear.  The  prob- 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING      319 

ability  of  changes  differs  in  different  lines  of  business,  however; 
some  lines  cannot  be  changed  radically,  and  others  have  been  me- 
chanically revolutionized  every  ten  or  fifteen  years,  and  are  likely  at 
any  time  to  be  revolutionized  again.  An  accounting  policy  which 
pays  no  attention  to  probabilities  of  this  sort  is  clearly  not  worth 
much.  Usually  something  should  be  set  aside  for  the  almost  in- 
evitable change. 

As  soon  as  an  attempt  is  made  to  provide  for  writing  off  valuation 
of  machinery,  question  arises  as  to  the  basis.  Shall  the  amount  of 
depreciation  be  taken  as  a  fixed  annual  sum,  as  an  increasing  sum,  as 
a  decreasing  sum,  or  shall  a  sinking  fund  be  established  ?  A  good 
argument  can  be  given  for  each ;  and  in  any  particular  case  the  most 
fitting  argument  should  decide.  A  machine  is  usually  efficient,  that 
is,  at  a  constant  production,  as  long  as  it  is  kept  in  use,  —  or  it  would 
be  abandoned ;  so  a  constant  annual  charge  may  be  the  best  device 
for  depreciation.  A  machine  depreciates  but  little  in  the  first  few 
years;  so  an  increasing  sum  is  an  excellent  device.  Since  the  true 
measure  of  cost  of  depreciation  is  not  mere  shrinkage  of  assets,  but 
this  shrinkage  plus  the  cost  of  repairs,  and  since  repairs  are  usually 
low  in  the  early  life  of  a  machine  but  high  in  the  late  years,  the  years 
of  low  repairs  should  see  heavy  arbitrary  writing  off  of  values  to  keep 
the  total  true ;  since,  moreover,  a  machine  is  in  early  years  compet- 
ing probably  against  old  machines,  and  is  in  later  years  competing 
against  new  machines,  it  can  afford  to  suffer  heavy  charges  in  early 
years  and  cannot  afford  them  in  late  years;  since,  again,  new  ma- 
chines may  at  any  time  change  the  methods  of  manufacture  and 
render  the  old  machines  obsolete,  no  time  is  too  early  to  set  aside  a 
fund  for  replacement :  so  a  plan  giving  heaviest  depreciation  sums 
in  the  early  years  is  an  excellent  device.  Finally,  if  funds  are  actually 
set  aside,  they  may  be  put  at  interest ;  and  so  the  early  installments 
will  increase  by  compound  interest  and  therefore  by  so  much  reduce 
the  requirement.  It  is  obvious  that,  taking  all  things  into  consid- 
eration, the  third  of  these  plans  —  providing  decreasing  sums  —  is 
most  often  likely  to  prove  satisfactory.  It  makes  allowance  for 
practically  every  contingency  in  the  conditions  under  which  it  is 
meant  to  apply ;  and  to  great  extent  it  combines  the  virtues  of  some 
of  the  other  plans.  For  example,  it  recognizes  the  low  repairs  at  the 
basis  of  the  second  plan ;  and  its  decreasing  rate  is  due  to  the  ac- 


320  ACCOUNTS 

cumulation  of  depreciation  sums  of  early  years  —  far  in  excess  of  the 
accumulation  of  a  sinking  fund. 

The  methods  of  determining  this  arbitrary  depreciation  are  vari- 
ous. It  is  possible  to  work  out  elaborate  mathematical  formulae  for 
the  purpose;  but  for  practical  purposes,  since  the  rate  is  more  or 
less  arbitrary  at  best,  simple  arithmetic  is  adequate.  The  difference 
between  the  cost  value  of  the  machine  and  its  scrap  value  represents 
the  shrinkage  to  be  divided  over  the  years.  A  very  satisfactory 
method  is  to  divide  the  shrinkage  by  the  sum  of  all  the  numbers 
representing  the  years  of  its  life,  and  depreciate  each  year  a  fraction 
comprising  the  number  of  the  years  to  run  as  a  numerator  and  the 
sum  of  year- numbers  for  a  denominator;  for  example,  if  the  life- 
time is  five  years,  add  5  and  4  and  3  and  2  and  i,  getting  15,  and  in 
the  first  year  write  off  -f^,  in  the  second  year  ^^3,  and  in  the  last 
year  ^^5.  This  method,  applied  to  a  machine  costing  $200  to  last  five 
years  with  a  final  scrap  value  of  $20,  would  work  out  as  follows : 


$200  -  $20  =  $1 80  shrinkage 

Denominator = 5 -f  4  +  3  +  2 -f- 1  = 

=  15.        $180-7-15  =  12 

ear         Depreciation  Fraction 

Depreciation 

Valuation 

0 

$200.00 

I                      j%   (of  $180) 

$60.00 

14000 

T% 

48.00 

92.00 

3                     t\ 

36.00 

56.00 

4                      1^ 

24.00 

32.00 

5                     iV 

12.00 

20.00 

This  gives  a  depreciation  of  one  third  in  the  first  of  the  five  years, 
and  of  only  one  fifteenth  in  the  last.  This  is  a  fair  distribution  for 
so  short  a  time.  It  is  very  nearly  a  steady  depreciation  of  35%  on 
the  last  valuation.^ 

^  A  good  many  writers  on  this  subject  recommend  the  determination  of  a  percentage 
which  applied  each  year  to  the  last  valuation  shall  reduce  it  as  desired.  A  formula 
for  this  is  given  in  Appendix  F,  page  430.  Its  application  for  the  situation  given  in  the 
text  gives  a  figure  for  depreciation  of  36.905%.  This  shows  values  of  the  machine 
in  succeeding  years  as  follows:  $200.00,  $126.19,  $79.62,  $50.24,  $31.70,  $20.00. 
That  method  is  applicable,  however,  only  when  a  scrap  value  is  expected  to  remain; 
for  no  percentage  but  100  will  ever  completely  wipe  out  the  last  valuation.  The 
method  described  in  the  text  is  applicable  in  all  cases,  for  it  is  based  not  on  a  per- 
centage of  reduced  valuation,  but  on  the  original  cost. 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     3  21 

A  common  objection  to  a  sinking  fund  is  that  usually  a  business 
can  earn  more  by  using  a  fund  than  it  can  get  in  interest  if  investment 
is  made  outside.  When  the  fund  is  left  in  the  business,  however,  one 
essential  caution  must  be  observed,  —  not  to  lock  up  the  fund  in 
machinery,  for  to  lock  up  in  machinery  of  an  old  type  a  fund  for  the 
purchase  of  new  machinery  is  to  pervert  it  entirely  from  its  function. 
Such  funds  must  always  be  utilized  in  something  which  can  be  con- 
verted into  cash  at  once. 

The  entry  upon  the  books  for  any  of  the  methods  described  is 
simply  a  debit  to  depreciation  and  a  credit  to  machinery  account  for 
the  annual  sum  written  off,  with  the  addition  of  sinking  fund  entries 
if  such  a  fund  is  established.  Then  depreciation  account  at  the  end 
of  the  year  is  closed  into  Profit  and  Loss.  This  reduces  the  figure 
of  net  profits.  Since  this  depreciation  is  nominal,  that  is,  registers 
not  the  loss  of  tangible  things  owned  by  the  company  but  merely 
a  recognition  that  certain  of  the  tangible  things  in  the  form  of 
machinery  have  shrunk  in  value,  the  entry  really  means  that  the 
amount  of  such  depreciation,  instead  of  being  distributed  as  divi- 
dend, is  retained  in  the  form  of  other  assets  not  machinery,  perhaps 
cash,  into  which  by  use  the  machinery  has  been  in  part  converted; 
or,  to  express  it  in  another  w^ay,  the  corporation  appears,  before 
depreciation  is  considered,  to  have  assets  more  valuable  than  they 
really  are,  and  the  books  show  that  certain  other  assets  which  might 
physically  be  distributed  as  dividend  are  retained  in  the  business 
as  an  offset  for  the  shrinkage  of  machinery. 

Still  a  fifth  method  of  figuring  depreciation  is  possible,  but  it  is 
hardly  wise  in  practice.  By  it  the  machinery  is  revalued  each  year, 
and  the  shrinkage  is  charged  against  revenue.  It  requires  practically 
as  much  figuring  as  the  other  methods,  for  any  one  valuing  old  ma- 
chinery will  inevitably  use  an  arbitrary  depreciation  rate.  It  lays 
the  account  open,  moreover,  to  constant  fluctuations  because  of 
changing  market  conditions,  whereas  for  manufacturing  purposes 
fluctuations  are  of  no  moment  and  a  constant  or  at  least  a  progres- 
sive rate  is  the  only  matter  of  consequence  after  the  machinery  has 
once  been  installed. 

Obviously  a  progressive  rate  of  depreciation  would  be  awkward 
for  use  in  calculating  machine  rates  for  distribution  of  burden,  for 
then  work  done  in  one  year  would  cost  more  or  less  than  work  done 


322  '  ACCOUNTS 

in  another  according  to  the  stage  of  progression.  The  provision  for 
depreciation  in  machine  rates  should  be  that  of  the  average,  or 
equal  division,  method,  so  that  the  charge  may  be  constant.  Re- 
pairs, too,  should  be  at  the  rate  of  the  average  of  the  Hfe  of  the 
machines.  The  charges  to  orders  for  any  particular  machine  may 
then  be  accumulating  a  fund  in  anticipation  of  later  mortality 
(similar  to  a  life-insurance  reserve),  on  one  hand,  or  they  may 
be  dropping  behind  depreciation  and  repairs  or  be  drawing  on 
previous  accumulations,  on  the  other  hand.  For  a  shop  with  ma- 
chines of  various  ages,  the  total  anticipations  would  usually  ap- 
proximate the  total  postponements,  and  the  annual  total  debits 
for  depreciation  and  repairs  would  closely  match  the  amount 
charged  to  orders  as  a  part  of  machine  rates.  The  only  complica- 
tion would  arise  with  a  shop  putting  in  much  new  machinery  at 
once  and  charging  depreciation  on  the  decreasing-ratio  plan.  Then 
except  so  far  as  a  saving  in  repairs  offset  the  heavy  charge  to  de- 
preciation, credits  to  the  machine-rate  accounts  would  not  absorb 
all  the  charges  to  depreciation,  and  a  considerable  figure  would 
remain  for  Burden  Adjustments.  A  shop  could  probably  not  afford 
to  use  that  very  liberal  policy  of  writing  off  plant,  however,  in  that 
sort  of  case. 

Manufacturing  accounts  are  given  in  published  reports  of  corpo- 
rations under  many  dissimilar  plans,  and  it  is  impossible  to  interpret 
them  except  with  some  recognition  of  the  fact  that  a  name  may 
stand  for  many  different  things  in  different  reports.  Always,  how- 
ever, if  the  reports  are  worth  anything,  they  can  be  interpreted  by 
general  bookkeeping  principles.  For  instance,  a  trial  balance  or  a 
balance  sheet  may  present  the  following  items :  Stores,  with  a  debit 
balance;  Wages,  with  a  debit  balance;  Sales,  with  a  credit  balance: 
then  an  inventory  may  be  given  for  Stores  and  for  Sales.  This 
clearly  cannot  be  worked  out  on  the  same  principle  as  the  scheme 
described  in  this  chapter,  for  in  this  case  we  have  Stores  with  both  a 
debit  balance  and  an  inventory,  whereas  under  the  scheme  given 
above  the  debit  balance  was  the  inventory.  The  only  explanation 
possible  here  is  that  the  Stores  debit  balance  indicates  stores  bought. 
Wages  account  here  cannot  be  similar  to  that  described  above, 
with  a  credit  to  the  employees  as  wages  were  earned  and  a  debit  as 
they  were  paid,  else  there  could  not  be  a  debit  balance;  and  so  a 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING    323 

debit  balance  here  must  mean  the  total  of  all  wages  paid.  Obviously, 
too,  if  Sales  has  an  inventory,  the  credit  balance  is  not  pure  profit, 
but  indicates  the  total  amount  of  sales ;  and  to  determine  profit  we 
must  work  out  an  income  sheet  somewhat  as  follows : 

Stores  debit  Sales  credit 

Inventory  of  stores  Inventory 

(difference)  Cost  of  material  (sum)  Product 

Wages  debit  Cost  of  product 

Expense,  etc.  (difference)   Gross  Profit 
(sum)  Cost  of  product 

The  combinations  that  may  arise  are  innumerable,  but  if  the 
accounts  are  good  for  anything  the  application  to  them  of  general 
principles  should  make  them  inteUigible. 

Let  us  try  another  case,  with  figures.  Suppose  the  following 
trial  balance  items,  showing  the  totals  rather  than  the  balances 
of  each  account,  are  found: 

Factory  Wages  $  75,000 

Factory  Pay  Roll  $  11, 000  4,000 

Stores  150,000  141,000 

General  Factory  Expense  ^IS, 000  175,000 

Manufacturing  466,000  380,000 

Stock  420,000  382,000 

Sales  382,000  425,000 

Each  should  be  possible  of  interpretation,  at  least  when  the  others 
are  known. 

With  both  Wages  and  Pay  Roll,  one  with  a  credit  balance  and  the 
other  with  a  debit,  two  accounts  are  obviously  kept  for  the  same 
thing  —  one  for  amounts  due  and  the  other  for  amounts  paid.  The 
failure  to  correspond  is  due  to  accrued  or  prepaid  items.  Here, 
clearly,  the  credit  to  Wages  is  the  wages  earned  by  employees 
(liability)  during  the  year,  and  hence  the  manufacturing  cost  for 
wages.  The  debit  to  Pay  Roll  is  the  wages  paid;  but  the  credit  to 
Pay  Roll  may  be  either  a  correction  entry,  in  which  case  the  debits 
are  really  but  $73,000,  or  a  balance  brought  down  at  the  last  clos- 
ing of  the  books,  in  which  case  $4000  of  the  pay  roll  of  last  period 
was  to  be  paid  in  this  period  and  hence  is  to  be  deducted  from  the 
cost  of  payments  in  this  period.    So  the  actual  payments  of  this 


324  ACCOUNTS 

period  on  account  of  this  period  are  only  $73,000  —  and  $2000  is 
still  due;  but  the  manufacturing  cost  is  $75,000. 

The  debit  to  Stores  is  the  amount  of  stores  handled,  inventory 
at  the  beginning  of  the  period  plus  purchases,  and  the  credit  is  the 
amount  issued  or  used  in  manufacturing  —  hence  debited  to  Man- 
ufacturing. The  balance,  or  $9000,  must  be  the  present  inventory 
of  stores. 

General  Factory  Expense  shows  no  balance.  This  has  evidently 
been  closed  out  to  Manufacturing,  as  it  should  be  except  for  any 
prepaid,  accrued,  or  inventory  items  (of  which  in  this  case  there 
are  none). 

Manufacturing  has  been  debited  for  all  costs  in  the  shop,  for  the 
other  accounts  have  been  closed  into  it.  We  have  already  found 
wages  (Wages,  Cr.)  $75,000,  stores  (Stores,  Cr.)  $141,000,  and 
general  expenses  (General  Factory  Expense,  Cr.)  $175,000,  a  total 
of  $391,000;  unless  there  are  other  items  not  included  among  those 
given  here,  the  difference  between  the  amoimt  which  we  have 
traced  and  the  total  debit,  or  $75,000,  must  be  mifinished  goods 
which  were  in  the  shop  and  debited  to  Manufacturing  at  the  close 
of  the  last  period  —  and  hence  inherited  by  this  period  as  the 
beginning  of  this  year's  operations.  The  credit  to  Manufacturing 
shows  the  goods  sent  from  the  shop  to  stock.  The  balance  of 
the  accoimt  shows  the  present  inventory  of  imfinished  goods,  or 
$86,000. 

The  debit  to  Stock  is  $40,000  more  than  the  credit  to  Manufac- 
turing during  this  period,  and  hence  this  amount  is  the  cost  value 
of  finished  goods  on  hand  at  the  beginning  of  the  period.  As  stock 
issued  (or  credits)  is  $38,000  less  than  the  debits,  the  present  in- 
ventory is  of  that  value  (supposing  no  shrinkage  below  manufac- 
turing costs). 

The  debit  to  Sales  is  the  same  figure  as  the  credit  to  Stock  —  be- 
cause nothing  is  debited  to  sales  until  it  is  sold.  So  the  debit  is  the 
cost  of  sales.  The  credits  are  for  the  selling  price,  and  hence  the 
balance  is  the  gross  profit. 

In  other  words,  these  figures  come  from  a  shop  employing  the 
bookkeeping  methods  discussed  in  this  chapter;  the  accounts  are 
tied  together  in  such  a  way  that  Stores,  Manufacturing,  and  Stock, 
are  real  accoimts,  and  Sales  is  nominal.  The  cost  figures  are  not 


\ 


PRINCIPLES  ILLUSTRATED  IN  FACTORY  ACCOUNTING     325 

merely  statistical  memoranda,  to  explain  costs,  but  get  into  the 
financial  books  and  arrive  ultimately  at  the  trial  balance  where 
their  correctness  is  submitted  to  trial-balance  tests.  From  these 
figures  we  are  able  to  construct  much  of  the  balance  sheet  both  of 
this  period  and  of  the  last.  The  last  must  have  shown  at  least  these 
items  of  those  which  we  have  just  traced: 

Unfinished  Goods  $75,000        Pay  Roll  $4,000 

Finished  Goods  40,000 

We  cannot  tell  how  many  of  the  stores  were  brought  over  and  how 

many  were  purchased  during  the  present  period,  for  this  account 

gets  no  transfers  from  others  and  hence  cannot  be  traced  back 

without  the  books.    The  new  balance  sheet  must  contain  these 

items: 

Stores  $  9,000       Pay  Roll  $2,000 

Unfinished  Goods  86,000 

Finished  Goods  38,000 

In  one  form  of  operating  statement  these  figures  would  result  as 
follows: 

Sales  $425,000 

Raw  material  consumed  $141,000 

Labor  75>ooo 

General  manufacturing  expenses  175,000 

Cost  of  new  work  $391,000 

Inventory  of  unfinished  goods  at  beginning  7 5, 000 

Inventory  of  finished  goods  at  beginning  40,000 

Cost  of  old  work  utilized  $115,000 

Inventory  of  unfinished  goods  at  end   $86,000 

Inventory  of  finished  goods  at  end         38,000 

Present  inventories  124,000 

Increase  of  inventories  9,000 

Cost  of  goods  sold  382,000 

Gross  profit  43}O0O 

Many  may  prefer  the  following  form  for  the  same  figures: 

Schedule  A 

Stores  at  beginning*  $  25,000 

Stores  bought^  125,000 

Stores  handled  $150,000 

Stores  at  end  9>ooo 

Stores  consumed  $141,000 

»  These  have  been  separated,  though  the  figures  were  not  shown  above,  for  the  sake  of  making  a  com- 
plete statement. 


326  ACCOUNTS 

Schedule  B 

Unfinished  goods  at  beginning  $75,000 

Unfinished  goods  at  end  86,000 

Increase  of  unfinished  goods  $11,000 

Schedule  C 

Finished  goods  at  beginning  $40,000 

Finished  goods  at  end  38,000 

Depletion  of  finished  goods  $2,000 

Schedule  D 
Sales  $425,000 

Stores  consumed  (Schedule  A)  $141,000 

Labor  7  5, 000 

General  manufacturing  expenses  175,000 

Depletion  of  finished  goods  (Schedule  C)  2,000 

$393,000 
Increase  of  unfinished  goods  (Schedule  B)  11,000 

Cost  of  goods  sold  382,000 

Gross  profit  $  43,000 

Either  of  these  statements  would  serve  as  a  supporting  schedule 
for  the  income  sheet.  The  choice  between  them  is  one  of  personal 
taste.  The  latter  is  more  convenient  when  much  detail  is  desired, 
for  the  separation  into  schedules  avoids  confusion  of  one  part  or 
aspect  of  the  business  with  another;  but  the  former  is  probably 
more  intelligible  when  details  are  few. 


i 


CHAPTER  TWENTY 

SOME   GENERAL    PRINCIPLES    ILLUSTRATED   IN  MUNICIPAL 

ACCOUNTING 

We  have  so  far  been  considering  accounts  chiefly  with  reference  to 
profit  and  loss.  Some  accounting  has  really  a  very  different  purpose, 
may  indeed  have  little  or  no  profit  or  loss  connected  with  it.  Such 
chiefly  is  the  accounting  of  municipalities  and  other  political  bodies. 
Though  the  accounting  of  administrative  organizations  like  a  city 
government  is  usually  pretty  bad,  excuse  can  be  found  in  the  fact 
that  the  system  in  use  is  likely  to  be  traditional.  In  the  old  days  of 
administrative  government  in  this  country,  the  financial  operations 
of  the  municipaUty  were  few.  The  city  needed  to  recognize  practi- 
cally nothing  more  than  the  responsibihty  of  the  town  treasurer. 
So  long  as  the  books  showed  that  he  had  accounted  for  every  cent 
received,  the  town  was  satisfied.  As  the  municipal  activity  grew, 
paving,  sewerage,  etc.,  were  gradually  added  on  a  small  scale.  The 
question  then  arose  whether  this  or  that  administration  of  town 
affairs  was  the  more  economical.  Each  administration  told  itself 
that  it  must  show  a  low  cost.  It  therefore,  when  possible,  neglected 
to  allow  for  depreciation  or  for  any  but  imperative  maintenance,  and 
showed  expenditure  at  its  lowest  basis.  When,  on  the  other  hand, 
conditions  reached  a  point  at  which  renewals  became  necessary,  the 
administration  in  charge  pointed  to  them  as  really  charges  upon  the 
past,  or  treated  them  as  capital  investments,  thus  shifting  the  odium 
of  increased  cost.  Most  cities  make  no  distinction  between  the  cost 
of  a  new  ferry-boat  and  the  cost  of  painting  an  old  one,  or  between 
the  cost  of  a  new  boiler  and  the  wages  of  a  man  to  run  it.  The  result 
of  all  this  is  that  in  most  cities  no  correct  figures  of  actual  cost  have 
ever  been  published.  The  community  perhaps  remembers  reported 
cost  in  the  years  when  good  luck  favored  the  administration,  so  that 
maintenance  and  renewal  were  low ;  and  all  higher  costs  have  been 
discounted  by  vague  excuses.  A  low  figure  has  become  a  standard 
which  no  administration  can  successfully  reject  unless  it  can  effect- 
ively point  to  extraordinary  cost  for  renewal  or  for  capital  account. 


328  ACCOUNTS 

It  takes  a  bold  administration  in  the  face  of  all  this  to  come  out  with 
accounts  that  represent  faithfully  what  expense  the  government 
has  incurred.  Practically  no  such  administration  has  appeared  in 
any  city.  It  would  be  hardly  fair  to  say  that  the  failure  is  due  always 
to  lack  of  courage :  it  may  be  quite  as  often  due  to  indifference  or 
to  ignorance  of  the  real  situation.  When,  a  few  years  ago,  people 
began  to  agitate  the  question  of  public  as  compared  with  private 
gas  works,  water  works,  telephone  service,  etc.,  they  came  to  see  that 
statistics  are  essential ;  and  then  they  came  to  see  that  the  figures  of 
municipal  cost  accounts  are  nearly  worthless. 

What  effect  has  the  common  practice  upon  the  value  of  municipal 
statistics  ?  Let  us  take  a  few  examples.  We  may  desire  to  learn  what 
is  the  cost  of  conducting  the  public  library  and  to  compare  it  with 
some  figures  for  other  cities.  Perhaps  the  city  owns  its  own  lighting 
plant  and  charges  nothing  to  the  library  for  lights.  Perhaps  the  city 
owns  its  own  water  supply  and  furnishes  to  the  library  water  to  run  a 
motor  for  its  book  elevators.  Perhaps  on  duty  at  the  library  are 
policemen,  who  serve  as  watchmen  night  and  day,  and  their  wages 
are  paid  not  from  library  funds,  but  from  police  funds.  If  the  library 
in  the  other  city  with  which  we  are  to  compare  this  one  has  to  pay 
high  lighting  charges,  water  charges,  and  watchmen's  wages,  a  com- 
parison of  costs  between  the  two  is  to  great  extent  worthless.  It 
would  be  impossible  usually  to  learn  whether  in  the  other  city  these 
costs  are  met  from  library  funds  or  from  funds  of  other  depart- 
ments. Obviously,  the  trouble  does  not  stop  here.  Suppose  we  wish 
to  compare  lighting  costs  for  this  city  with  lighting  costs  in  another 
where  the  library  charges  are  paid  independently.  Our  comparison 
is  thrown  out  of  balance.  The  difference  will  be  slight  for  one  build- 
ing, but  if  the  same  careless  accounting  prevails  throughout  the  city 
departments,  in  the  City  Hall,  fire  stations,  police  stations,  etc.,  the 
difference  may  be  more  than  the  whole  difference  in  cost  between 
private  management  and  public  management.  Similarly,  the  com- 
parative cost  of  water  and  of  police  service  in  the  two  cities  is  by 
so  much  thrown  out. 

The  chances  of  misrepresentation  in  city  affairs  are  far  more 
numerous  and  important  than  at  first  sight  appear.  If  the  water 
department  is  careless,  it  may  not  charge  the  fire  department  for 
the  great  consumption  of  water  at  fires,  and  both  water  cost  and  fire- 


PRINCIPLES  IN  MUNICIPAL  ACCOUNTING  329 

protection  cost  are  misrepresented  as  compared  with  cities  where 
water  must  be  paid  for.  If  the  water  department  borrows  fuel,  and 
does  not  repay  it,  from  the  public  buildings  department,  and  per- 
haps then  lends  fuel  to  the  street-cleaning  department  for  tugboats 
hauling  scows  to  deep  water,  all  three  departments  are  misrepresented 
and  a  comparison  is  by  so  much  misleading. 

Usually,  too,  city  statistics  of  cost  include  so  many  peculiarities  of 
accounting  that  an  outsider  can  do  but  little  with  them,  and  the 
heads  of  the  departments  themselves  cannot  always  tell  exactly 
what  the  figures  mean.  Indeed,  the  greatest  security  of  the  host  of 
grafters  whose  doings  have  been  disclosed  so  widely  in  the  last  few 
years  is  in  the  fact  that  in  practically  no  city,  county,  or  State,  or 
even  in  the  national  government,  has  an  adequate  basis  been  es- 
tablished for  determining  what  should  be  the  cost  for  the  services 
secured. 

Work  which  in  some  cities  is  done  by  one  department  is  in  others 
required  of  another  department.  A  comparison  of  department  costs 
is  useless  unless  details  of  this  sort  can  be  learned.  For  example,  one 
city  will  charge  to  the  paving  department  what  another  charges  to 
the  sewer  department,  and  yet  one  of  these  serves  public  conven- 
ience and  the  other  public  health ;  so  a  comparison  of  the  two  cities 
in  their  ratio  of  expenditure  for  public  health  is  by  this  difference 
misleading. 

Municipal  accounts  are  further  confused  by  the  fact  that  there  are 
likely  to  be  three  different  points  of  view  from  which  the  statistics  are 
reported.  Since  the  heads  of  departments  usually  are  immediately 
responsible  for  the  distribution  of  funds,  their  point  of  view  is  that 
of  the  practical  man  whose  interest  is  chiefly  in  the  details  of  his  own 
work;  and  their  reports  are  on  that  technical  administrative  basis. 
The  accounts  of  these  heads  of  departments,  however,  are  likely  to 
be  recast  by  the  auditor,  through  whose  hands  they  must  pass.  He 
must  see  to  it  that  the  expenditures  are  out  of  particular  funds  or 
appropriations  at  his  disposal.  His  classification  of  expenditures, 
then,  is  likely  to  be  based  not  at  all  upon  their  particular  purpose, 
but  upon  the  peculiarities  of  the  legislative  acts  authorizing  them; 
so  his  point  of  view  is  technically  legal.  Finally,  some  cities  have 
organized  accounting  departments,  whose  purpose  is  principally  eco- 
nomic.   Such  a  department  will  recast  the  accounts  on  the  basis  of 


330  ACCOUNTS 

the  social  service  accomplished  by  the  expenditure.  It  may  happen 
in  many  cases,  therefore,  that  three  sets  of  accounts  for  the  same 
expenditure  are  placed  before  the  public,  —  one  based  on  mere  ad- 
ministrative or  engineering  convenience,  one  on  mere  legal  chance, 
and  one  on  economic  principles.  Unless  one  knows  under  which 
classification  the  accounts  at  hand  happen  to  fall,  one  is  likely  to 
find  difficult  any  intelligent  judgment  in  a  comparison  of  one  city 
with  another  or  in  an  attempt  to  learn  actual  cost  for  any  particular 
service. 

An  effort  has  been  making  for  a  number  of  years  to  secure  uniform 
accounting  in  the  different  cities  of  the  country,  so  that  comparisons 
shall  be  possible  for  economists,  sociologists,  and  students  of  ad- 
ministrative matters.  The  State  of  Ohio  has  passed  a  law  requiring 
all  municipal  accounts  to  be  made  on  a  certain  form,  but  this  has  been 
done  so  recently  that  the  full  benefit  of  the  results  has  not  yet  been 
attained.  Several  cities  in  Massachusetts  have  been  for  a  number 
of  years  attempting  this  sort  of  thing.  Several  large  cities  in  different 
parts  of  the  country  have  joined  in  this  movement.  The  most  that 
can  be  said  is  that  the  tendency  is  strongly  in  that  direction,  and  that 
through  the  efforts  of  the  National  Municipal  League,  which  has 
taken  the  initiative  in  this  matter,  it  is  probable  that  in  a  few  years 
it  will  be  possible  to  compare  in  many  details  many  cities  of  about 
the  same  class.  At  present,  though  a  number  of  cities  have  adopted 
in  the  main  a  plan  outlined  by  the  League,  they  have  not  yet  quite 
agreed  upon  a  uniform  schedule,  and  since  each  in  its  own  way  is 
attempting  to  do  the  thing  ideally,  just  enough  diversity  remains  to 
throw  considerably  out  of  accuracy  the  judgments  that  one  might 
form  by  comparing  reported  figures. 

The  scheme  as  outlined  by  the  National  Municipal  League  divides 
the  total  expenditures  of  a  city  into  four  groups :  first,  ordinary  ex- 
penditures; second,  extraordinary  expenditures;  third,  trust  funds; 
fourth,  bookkeeping  items.  Receipts  are  divided  on  the  same  plan. 
The  ordinary  items  would  consist  mainly  of  taxes  and  the  expendi- 
tures met  from  them  or  for  their  collection  and  administration.  The 
extraordinary  items  are  money  borrowed  or  raised  in  other  capital 
ways  and  the  expenditures  made  from  such  receipts.  Trust  funds 
are,  of  course,  in  a  class  by  themselves,  and  the  expenditures  must 
bear  an  exact  relation  to  receipts;  obviously  for  purposes  of  good 


PRINCIPLES  IN  MUNICIPAL  ACCOUNTING  33 1 

accounting  the  distinction  between  trust  funds  and  ordinary  and 
extraordinary  receipts  is  rather  legal  than  economic.  The  book- 
keeping items  are  sums  which  do  not  affect  the  ultimate  resources 
or  liabilities  or  expenses  of  the  city,  and  may  be  illustrated  by  taxes 
collected  for  the  State  and  ultimately  turned  over  to  it,  or  sums 
borrowed  temporarily  while  awaiting  the  payment  of  taxes.  Roughly 
speaking,  at  least  theoretically,  extraordinary  expenditures  are  for 
capital  account,  as  for  bridges,  sewers,  etc.,  and  by  so  much  may  be 
taken  to  represent  investments;  but  oftentimes  what  appears  to  be 
capital  expenditure  is  not  so  in  reality. 

These  four  groups  are  next  subdivided,  in  the  scheme  of  the  Na- 
tional Municipal  League,  on  an  economic  or  social  basis.  This 
schedule  is  worth  reproduction  here,  for  though  exceptions  may  be 
taken  to  it  here  and  there,  it  is  in  the  main  an  excellent  illustration 
of  classification  of  expenditure  on  sound  principles. 
I.   General  government 

1.  Mayor's  office 

(a)  Salary 

(b)  Incidentals 

2.  Legislative  department 

(a)  City  Council 

(b)  City  Clerk 

3.  Law  department 

4.  Finance  department 

5.  Bureau  of  elections 

6.  Printing 

7.  Buildings  not  in  other  departments 

8.  Registration 

9.  Miscellaneous 

II.   Protection  of  life,  health,  and  property 

1.  Police  department 

2.  Fire  department 

3.  Courts 

4.  Jails,  prisons,  and  reformatories 

5.  Health  department 

6.  Opineterif^s 

7.  Inspection  of  buildings 

8.  Militia  and  armories 

9.  Miscellaneous 


332  ACCOUNTS 

m.   Public  charity 

1.  Hospitals 

2.  Care  of  insane 

3.  Homes  for  the  aged  and  for  defectives 

4.  Almshouses  and  workhouses 

5.  Lodging  houses 

6.  Outdoor  relief 

7.  Miscellaneous 
IV.  Public  works 

1.  Administrative  expenses 

2.  Opening  and  grading  streets 

3.  Street  paving 

4.  Sidewalks 

5.  Street  cleaning 

6.  Street  sprinkling 

7.  Street  lighting 

8.  Garbage  removal 

9.  Snow  removal 

10.  Sewers  and  sewage  disposal 

11.  Bridges 

12.  Miscellaneous 
V.   Public  industries 

1.  Water  works 

2.  Gas  works 

3.  Electric  light  plants 

4.  City  real  estate 

5.  Markets 

6.  Docks  and  wharves 

7.  Transit  subways 

8.  Subways  for  pipes  and  wires 

9.  Miscellaneous 

VI.  Education,  recreation,  and  art 

1.  Schools 

2.  Libraries 

3.  Museums  and  art  galleries 

4.  Recreation 

(a)  Parks    (6)  Playgrounds    (c)  Gymnasia 

5.  Baths 

6.  Celebrations 

7.  Miscellaneous 


PRINCIPLES    IN    MUNICIPAL  ACCOUNTING  333 

It  is  easy  to  criticise  any  scheme  of  this  sort.  For  example,  though 
the  costs  of  the  health  department  and  of  cemeteries  are  in  group  II, 
the  costs  of  garbage  removal  and  of  sewage  disposal  are  in  group  IV, 
and  the  cost  of  baths  is  in  group  VI ;  yet  the  primary  purpose  of  all 
these  expenditures  is  public  health.  If,  on  the  other  hand,  these  were 
all  in  the  same  group,  certain  other  classifications  would  be  thrown 
out.  The  general  criticism  of  the  schedule  is,  perhaps,  that  it  is 
governed  rather  by  administrative  or  economic  considerations  than 
by  sociological  —  as  instanced  by  the  cases  above.  The  main  thing 
to  be  desired,  however,  is  sufficient  clearness  and  uniformity :  if  these 
are  provided,  as  they  pretty  satisfactorily  are  by  this  schedule,  the 
accounts  can  be  interpreted  intelligently  from  any  point  of  view. 

Few  cities  have  tried  to  construct  a  balance  sheet ;  but  to  do  so 
seems  altogether  worth  while.  Cambridge,  Massachusetts,  did  so  a 
few  years  ago  with  interesting  results.  The  available  assets  are  di- 
vided into  numerous  groups,  such  as  current,  contingent,  trust,  and 
sinking  fund.  The  fixed  assets  are  distinct.  The  liabilities  are  divided 
into  current,  contingent,  trust,  and  bonded-debt  groups.  A  com- 
parison of  available  assets  with  total  liabilities  shows  the  excess  of 
liabilities,  —  practically  net  debt.  Then  to  the  available  assets  are 
added  the  fixed  assets  (unavailable  city  property  reported  by  de- 
partments), and  this  total  is  compared  with  total  liabilities,  showing 
a  surplus.  In  other  words,  this  surplus  represents  what  the  city  still 
has  to  show  for  taxes  collected  in  past  years.  Included  in  the  contin- 
gent assets  are  delinquent  taxes,  and  included  in  the  contingent 
liabilities  are  contractors'  payments  retained,  disputed  sums,  etc. 
This  Cambridge  form  appears  as  follows: 

Assets  Liabilities 

[All  figures  are  thousands  of  dollars.] 


Current 

519.8 

Current 

94-5 

Contingent 

276.5 

Contingent 

241.4 

Trust 

85.8 

Trust 

85.8 

Sinking  Funds 

2,371-8 

Bonded  Debt 

8,840.5 

Total  available 

3,253-9 

Total 

9,262.2 

Total  fixed 

11,151.8 

Surplus 

5,143-5 

14,405-7  14,405-7 


A  bookkeeping  peculiarity  of  administrative  accounts  is  that 
money  is  expended  by  departments  having  no  income.   Such  ex- 


334  ACCOUNTS 

penditure  is  usually  by  order  on  the  treasury,  to  apply  on  particular 
appropriations.  Care  must  be  taken  that  the  authority  to  spend  is 
not  exceeded.  Sometimes  unexpended  balances  from  previous  years 
may  be  spent  in  addition  to  the  current  appropriation,  and  some- 
times they  must  be  covered  into  the  treasury.  Sometimes  miscel- 
laneous income  may  be  added  to  the  appropriation.  A  convenient 
form  for  watching  the  relation  between  expenditure  and  appropria- 
tion lies  in  departmental  ledger  accounts  kept  in  addition  to  the 
ordinary  accounts  for  asset  and  liability  or  revenue  and  expense. 
Such  accounts  would  be  statistical  only,  but  they  would  be  kept 
by  double  entry.  For  example,  if  all  estimated  revenues  of  a  de- 
partment are  appropriated  to  its  use,  a  debit  to  Estimated  Reve- 
nue Balances  and  a  credit  to  Appropriation  Balances  shows  both 
assets  and  the  right  to  use  assets.  On  the  sending  of  bills  (water 
bills,  for  example),  a  debit  to  Unrealized  Claim  Balances  with  a 
credit  to  Estimated  Revenue  Balances  shows  the  substitution  of 
assets  in  sight  for  assets  estimated.  On  incurring  debt,  a  debit  to 
Appropriation  Balances  with  a  credit  to  Contract  Liabilities  or 
Order  Liabilities,  according  as  the  liabilities  are  on  contracts  or  on 
open  market  orders,  shows  a  reduction  both  in  the  right  to  spend 
money  and  in  the  assets  unencumbered  for  spending  —  for  these 
liabilities  are  in  effect  deductions  from  assets.  On  the  collection 
of  cash  from  bills  sent  out,  a  debit  to  Current  Balances  and  a  credit 
to  Unrealized  Claim  Balances  shows  the  change  in  the  character 
of  the  assets.  Then  the  balances  of  these  accounts  will  tell  at 
all  times  how  much  estimated  revenue  is  expected  to  be  derived 
from  charges  not  yet  made,  how  much  appropriation  has  not  yet 
been  disposed  of,  how  much  revenue  is  actually  in  sight  (both 
claims  and  current)  for  meeting  liabilities  incurred.  All  desired 
information  is  thus  available. 

To  illustrate  this,  let  us  suppose  that  a  city  department  (i)  has 
an  estimated  revenue  of  $450,000,  and  receives  appropriations  al- 
lowing it  to  spend  $400,000;  (2)  sends  out  bills  for  $350,000;  (3) 
incurs  liabilities  on  contracts  for  $100,000  and  on  open  market 
orders  for  $50,000;  (4)  collects  $100,000  on  bills;  (5)  pays  $50,000 
on  contracts.  We  shall  then  have  entries  to  these  statistical  ac- 
counts, besides  the  regular  entries  for  Accounts  Receivable  and 
Cash  and  Expense,  as  follows: 


PRINCIPLES  IN  MUNICIPAL  ACCOUNTING  335 


(i)  Estimated  Revenue  Balances 

450,000 

To  Appropriation  Balances 

400,000 

Estimated  Surplus 

50,000 

(2)  Unrealized  Claim  Balances 

350,000 

To  Estimated  Revenue  Balances 

350,000 

(3)  Appropriation  Balances 

150,000 

To  Contract  Liabilities 

100,000 

Order  Liabilities 

50,000 

(4)  Current  Balances 

100,000 

To  Unrealized  Claim  Balances 

100,000 

(s)  Contract  Liabilities 

50,000 

To  Current  Balances 

50,000 

This  gives  the  following  trial  balance  of  ledger  totals: 

Estimated  Revenue  Balances  100,000 

Appropriation  Balances  250,000 

Estimated  Surplus  50,000 

Unrealized  Claim  Balances  250,000 

Current  Balances  50,000 

Contract  Liabilities  50,000 

Order  Liabilities  50,000 

400,000        400,000 


This  shows  all  the  facts,  which  may  be  siunmarized  as  follows: 

250,000 


Authority  to  incur  further  liabilities 

To  be  met  by: 

Revenue  not  yet  billed 

100,000 

Billed  claims 

250,000 

Available  cash 

50,000 

400,000 
Less  liabilities 
For  amount  to  be  transferred       50,000 
Contracts  outstanding  50,000 

Open  market  orders  outstanding  50,000        150,000 


250,000 


Entries  to  these  accounts  would  be  made  usually  only  at  inter- 
vals (not  of  course  for  each  bill  collected),  but  as  often  as  the  situa- 
tion requires.  As  they  are  absolutely  independent  of  the  ordinary 
accounts  they  make  no  confusion. 

A  feature  of  accounting  almost  universal  in  administrative  affairs, 
but  common  also  in  other  connections,  is  sinking  funds.  These 
differ  from  ordinary  reserve  funds  because  when  once  started  they 


336  ACCOUNTS 

go  on  increasing  of  their  own  momentum,  and  because  they  are 
usually  maintained  for  the  specific  purpose  of  paying  funded  debt. 
The  sinking  fund  is  an  old  device  and  is  thought  to  have  about  it  a 
certain  mystical  sacredness.  The  operation  of  a  sinking  fund  in  its 
simplest  form  is  as  follows:  a  certain  simi  is  set  by  as  a  sort  of  nest 
egg;  with  this  sum  as  many  as  possible  of  the  bonds  to  be  redeemed 
are  purchased;  then  the  government  or  corporation  collects  interest 
from  itself  on  these  bonds  as  interest  becomes  due,  and  adds  that  to 
the  fund.  That  is,  it  invests  money  in  buying  bonds,  upon  which  in 
turn  interest  is  collected  and  invested  in  more  bonds,  and  so  on  in- 
terminably. The  government  itself  pays  interest  to  itself,  and  this 
interest  continually  accumulates  more.  It  is  nothing  but  compound 
interest,  and  there  is  really  nothing  magical  about  it.  Of  course,  no 
one  can  get  rich  by  paying  interest  to  himself,  and  no  government  is 
saving  anything  by  this  process.  If  nothing  were  set  aside  at  the 
start,  an  investment  of  capital  earning  interest  and  spent  in  buy- 
ing up  the  government's  own  debt,  nothing  would  be  saved.  As  a 
matter  of  fact,  however,  a  sinking  fund  is  not  usually  quite  so  simple 
as  described,  for  usually  an  annual  appropriation  is  added  from 
taxes,  so  that  the  figures  may  be  like  this : 


Years 

I 
2 

3 
4 

5 


Total  Bonds  at  Begin- 
ning of  Year 


$1,050 
2,152.50 
3,310.12 
4,525-62 


Annual  Invest- 
ment 

$1,000 
1,000 
1,000 
1,000 
1,000 


Total  invested  at  Be- 
ginning of  Year 

$1,000 
2,050 

3,152.50 
4,310.12 
5,525.62 


Interest  earned 

$50 
102.50 
157.62 
215-50 


This,  of  course,  gives  a  rather  rapid  increase  in  the  fund,  not  merely 
by  means  of  the  principal,  but  also  by  means  of  the  interest.  It  is 
now  to  be  noted  that,  if  we  assume  to  be  unchanged  the  city's  re- 
sources and  its  willingness  to  pay  debt,  the  conditions  would  have 
been  exactly  the  same  without  the  sinking  fund.  Let  us  assume,  then, 
that  the  city  will  spend  $1000  a  year  in  paying  off  its  debt,  and  that 
instead  of  establishing  a  sinking  fund  it  simply  buys  bonds  and  can- 
cels them.  If  $1000  has  been  spent  in  this  way  in  the  first  year  and 
the  bonds  cancelled,  in  the  next  year  the  city's  expenses  will  be  re- 
duced to  the  extent  of  the  saved  interest ;  and  if  this  saving  is  now 


PRINCIPLES  IN  MUNICIPAL  ACCOUNTING  337 

invested  in  the  bonds,  as  it  may  be  since  the  city  has  escaped  so 
much  interest,  we  shall  find  in  that  year  that  $1050  may  be  spent 
for  the  debt.  Each  year's  cancellation  of  bonds,  of  course,  means 
a  saving  of  interest  not  only  for  that  year  but  for  all  subsequent 
years.  This  plan  foUovi^ed  year  after  year  will  show  the  following 
results  (distinguishing  the  saving  on  each  year's  cancellation  of 
bonds) : 
Invested  from  Income  Saving 

ist  year  $1,000  $50 


2d        " 

1,050 

50  +  52.50=102.50 

3d      " 

1,102.50 

50  +  52.50  +  55.12=157.62 

4th     " 

1,157.62 

50  +  52.50  +  55.12  +  57.88=215.50 

5th     " 

1,215.50 

Total 

5,525-62 

ll'  This  compared  with  the  other  table  shows  that  at  the  end  of  the 
period  exactly  the  same  result  has  been  produced  with  no  greater 
sacrifice.  In  other  words,  the  sinking  fund  is  of  absolutely  no  in- 
trinsic value.  It  does  not  earn  anything  for  the  city,  and  the  city 
can  pay  no  more  with  the  sinking  fund  than  without  it.  Why,  then, 
is  the  hue  and  cry  raised  by  any  attempt  to  tamper  with  the  fund  ? 
The  fact  is  that  in  the  eye  of  the  public  a  sinking  fund  has  a  sort  of 
sanctity,  and  the  legislator  or  administrative  officer  who  would  not 
scruple  to  tamper  with  other  arrangements  will  hesitate  long  before 
misusing  such  a  fund.  The  public  complains  at  seeing  taxes  levied  to 
pay  off  debt,  but  somehow  thinks  a  sinking  fund  a  sort  of  goose  that 
lays  golden  eggs.  This  is  just  the  virtue  of  the  sinking  fund.  It  en- 
ables a  government  or  a  corporation  to  pay  debt  without  opposition, 
and  the  power  of  the  fund  lies  wholly  in  the  prejudice  in  its  favor. 
Indeed,  sometimes  paying  debt  by  a  sinking  fund  costs  more  than 
paying  it  by  any  other  process,  for,  unfortunately,  sinking  fund  com- 
missioners are  sometimes  required  by  law  to  buy  the  particular  debt 
which  the  fund  is  intended  to  wipe  out,  and  when  that  debt  is  at 
a  high  premium,  owing  to  market  conditions,  actual  loss  may  be 
suffered.  Usually  however,  even  under  those  conditions,  the  public 
still  clinj^s  to  the  notion  of  the  golden  eggs. 

The  accounting  of  sinking  funds  is  likely  to  be  a  little  puzzling. 
So  far  as  the  funds  have  been  taken  out  of  earnings,  they  constitute 

'     a  liability  of  the  business  or  administrative  body ;  and,  therefore,  a 


338  ACCOUNTS 

fund  must  appear  on  the  credit  side  of  the  balance  sheet.  The  prop- 
erty in  the  fund  itself,  on  the  other  hand,  is  always  a  resource.  If 
such  a  fund  has  arisen  simply  from  the  conversion  of  one  kind  of 
property  into  another,  however,  it  will  appear  on  the  assets  side  only. 
Often  a  sinking  fimd  is  intrusted  to  specific  persons  called  sinking 
fund  commissioners,  and  they,  as  trustees,  are  considered  as  debtors 
to  the  corporation,  that  is,  are  held  responsible.  Under  such  condi- 
tions, the  books  of  the  corporation  proper  need  not  give  details  for 
the  management  of  the  fund.  The  commissioners  are  of  course 
obliged  to  record  details,  keeping  record  of  all  increases  of  the  fund, 
and  all  expenditures  on  its  account,  and  all  investments.  Then,  at 
suitable  intervals,  the  books  of  the  main  corporation  are  made  to 
agree  with  the  books  of  the  commissioners,  through  a  report  sent 
by  the  commissioners  to  the  body  which  they  serve. 

Let  us  suppose  that  commissioners  are  appointed  to  administer 
such  a  fund  and  that  they  are  to  be  given  $10,000  a  year  and  any 
interest  on  the  fund,  for  the  purposes  of  ultimate  bond  retirement, 
though  no  bonds  are  to  be  canceled  until  all  have  been  acquired. 
The  bonds  pay  4^%.  Supposing,  for  simplicity,  that  all  transac- 
tions occur  on  January  i  (when  the  instalment  is  due  and  paid, 
and  all  free  cash  is  spent  in  buying  bonds)  and  on  December  31 
(when  interest  earned  is  collected),  we  get  the  following  entries: 


Jan.    I,  191S 

City  Treasury  ^ 
To  Sinking  Fund  Requirements 

$10,000 

$10,000 

Cash 
To  City  Treasury 

$10,000 

$10,000 

Sinking  Fund  Bonds 
To  Cash 

10,000 

10,000 

Dec.  31,  1915 

Cash 
To  Sinking  Fund  Income 

450 

450 

Jan.    I,  1916 

City  Treasury 
Sinking  Fund  Income 
To  Sinking  Fund  Requirement 

10,000 
450 

10,450 

Cash 
To  City  Treasury 

10,000 

10,000 

Sinking  Fund  Bonds 
To  Cash 

10,450 

io,4SO 

»  This  entry  is  made  to  provide  that  in  case  of  neglect  of  the  city  treasurer  to  transfer  the  money, 
or  of  the  legislative  body  to  make  appropriation,  the  commissioners  may  show  that  they  have  a  claim 
for  the  uses  of  the  fund. 


I 


PRINCIPLES  IN  MUNICIPAL  ACCOUNTING  339 

A  trial  balance  of  the  commissioners'  books  at  this  stage  follows: 

Sinking  Fund  Bonds  $20,450 

Sinking  Fund  Requirements  $20,450 

This  assumes,  of  course,  that  all  the  cash  can  be  at  once  invested 
—  which  is  improbable.  If  the  city  treasury  did  not  pay  promptly, 
and  if  not  all  cash  was  invested,  balances  would  show  on  the  cor- 
responding accounts.  Interest  is  credited  to  Sinking  Fund  Income 
so  that  a  permanent  record  may  be  kept  of  the  amount  of  the  fund 
earned  by  the  fund  itself  as  distinguished  from  the  amount  con- 
tributed from  the  city  treasury.  Income  should  be  closed  to  Re- 
quirements as  soon  as  it  is  ready  for  investment.  The  account  for 
requirements  is  the  measure  of  liabiHty  of  the  commissioners. 

With  the  rapid  adoption  of  serial  bonds  among  municipalities, 
sinking  funds  are  losing  their  importance.  The  principles  of  serial 
bonds  are  discussed  on  page  200. 


I 


CHAPTER  TWENTY-ONE 

SOME     MISCELLANEOUS     APPLICATIONS     OF     GENERAL 

PRINCIPLES 

/.  The  Treatment  of  Commercial  Discounts 

The  common  method  of  treating  discount  allowed  for  early  pay- 
ment of  bills  is  to  debit  an  account  called  Merchandise  Discount 
and  credit  the  customer.  Conversely,  for  all  discounts  taken  on 
purchases  it  is  common  to  credit  Merchandise  Discount  and  debit 
the  firm  from  which  the  purchase  was  made.  In  the  end,  Mer- 
chandise Discount  is  commonly  closed  out  into  Merchandise.  The 
result  of  this  method  is  to  show  the  actual  occurrence  so  far  as  things 
appear  on  the  surface,  —  that  is,  to  charge  merchandise  account  for 
the  actual  net  payment  for  merchandise  bought  and  credit  that  ac- 
count for  the  net  amount  received  on  merchandise  sold.  This  ap- 
pears to  be  a  desirable  thing.  As  we  saw  in  discussing  the  main 
principles  of  the  balance  sheet,  however,  it  is  likely  to  happen  that 
the  worse  the  credit  of  the  concern  buying  goods,  the  higher  will 
appear  the  value  of  its  merchandise  on  the  books.  If,  that  is  to  say,  a 
concern  has  such  poor  credit  that  it  can  pay  its  bills  only  at  the  last 
moment,  it  is  paying  the  maximum  price  and  its  merchandise  ac- 
count is  debited  for  that  price.  A  concern  with  good  credit  and  good 
management,  on  the  other  hand,  will  always  take  the  highest  dis- 
count offered  and  will  have  a  correspondingly  low  valuation  for 
merchandise.  The  same  goods,  bought  from  the  same  dealer,  on  the 
same  offered  terms,  will  have  a  higher  book  value  for  a  poor  con- 
cern than  for  a  good  one.  This  exposes  at  once  the  objection  to 
allowing  Merchandise  to  be  affected  in  any  way  by  discounts.  If  the 
terms  offered  on  a  bill  of  goods  are  6%  in  ten  days,  5%  in  thirty  days, 
and  net  sixty  days,  it  is  obvious  that  a  man  who  pays  his  bill  in  ten 
days  is  paying  much  more  nearly  the  real  cost  of  the  merchandise 
than  the  man  who  pays  his  bill  at  the  end  of  the  sixty  days.  The  cost 
of  manufacturing  and  distributing  the  goods  sold  to  the  sixty-day 
man  is  no  greater  than  that  of  the  goods  sold  to  the  ten-day  man. 


APPLICATIONS  OF  GENERAL  PRINCIPLES  34I 

In  other  words,  the  difference  of  6%  has  nothing  to  do  with  the  cost 
of  manufacturing  or  distributing  the  goods.  It  has  nothing  whatever 
to  do  with  the  merchandise.  It  is  simply  a  payment  for  delay  and 
risk.  It  is  not  based  on  the  usual  interest  rate,  to  be  sure ;  but  the 
charge  is  still  of  the  nature  of  interest.  In  all  other  particulars  except 
this  matter  of  delay  in  payment,  the  bills  are  the  same.  It  is  obvious, 
therefore,  that  the  6%  should  not,  except  temporarily,  enter  into  the 
merchandise  account.  What  is  the  proper  debit  to  Merchandise  for 
goods  bought  ?  If  dealers  can  sell  the  goods  at  6%  less  than  the  billed 
price,  the  billed  price  less  6%  is  the  natural  price  of  the  goods.  If, 
indeed,  they  will  give  7%  for  spot  cash,  the  billed  price  less  7%  is  the 
only  proper  charge  to  Merchandise. 

This  may  seem  too  great  a  refinement  of  the  principle  of  distinc- 
tions ;  but  it  is  a  matter  of  far  greater  importance  than  most  business 
men  realize.  It  is  easy  enough  for  a  man  to  say,  "If  the  discounts 
that  I  take  amount  to  as  much  as  the  discounts  that  I  give,  I  am  los- 
ing nothing  by  this  method  of  conducting  my  business."  The  obvious 
answer  is  that  there  is  no  necessary  relation  between  the  discounts 
that  he  takes  and  the  discounts  that  he  gives.  It  is  not  necessary,  in 
order  to  receive  the  largest  price  on  goods  sold,  that  he  shall  pay 
the  largest  price  on  goods  bought.  If  a  man  w^hose  credit  is  good 
can  borrow  money  at  6%  per  year,  it  is  the  height  of  foolishness  to 
borrow  money  at  6%  for  50  days,  —  as  he  is  doing  when  he  is  of- 
fered 6%  discount  in  ten  days  but  pays  net  in  sixty  days.  The  dis- 
count lost  can  under  no  circumstances  be  looked  upon  as  anything 
else  than  a  sort  of  interest  payment,  —  though  at  a  much  higher  rate 
than  normal.  Taking  or  giving  a  discount  is  not  earning  anything 
or  losing  anything :  it  is  simply  pa}dng  or  realizing  the  normal  price. 

Accounting  should  show  what  are  the  costs  of  conducting  various 
parts  of  the  business  and  what  results  would  be  attained  by  any  pos- 
sible economies.  What  a  man  really  needs  to  know,  then,  is  not  what 
discounts  he  has  taken,  but  w^hat  discounts  he  has  lost.  A  charge 
should  be  made  not  for  discounts  which  his  customers  take,  but  for 
discounts  which  he  himself  fails  to  take.  A  business  man  who,  at  the 
end  of  the  year,  is  presented  with  a  ledger  account  showing  that  he 
has  lost  in  discounts  $500,  is  not  going  to  offset  that  loss  by  discounts 
forfeited  by  his  customers  even  to  the  amount  of  $700.  He  is  going 
to  see  at  a  glance  that  the  discounts  lost  by  his  customers  are  clear 


342  ACCOUNTS 

gain  to  him,  and  would  have  been  received  just  the  same  whether  he 
had  lost  discounts  on  his  own  purchases  or  not.  He  is  going  to  realize 
that  the  $500  lost  has  brought  no  compensating  gain  except  the 
saving  of  interest  that  he  would  perhaps  have  had  to  pay  if  he  had 
borrowed  money  at  the  normal  rate  to  enable  him  to  discount  his 
bills;  but  borrowing  at  6%  to  save  42%  is  worth  while. 

The  proper  treatment  of  these  discounts,  then,  would  shift  the 
point  of  view  from  that  commonly  maintained.  Since  no  one  is 
absolutely  sure,  at  the  time  a  bill  is  sent  out  or  received,  whether 
the  discount  will  be  taken  or  not,  the  goods  must  be  entered  at  the 
full  price.  In  any  case,  whether  the  discount  be  taken  or  not,  the 
amount  should  be  ultimately  reduced  by  the  discount,  for  the  bill- 
ing price  includes  an  item  not  properly  called  merchandise,  as  has 
been  shown.  The  only  question  is  concerning  the  account  ultimately 
responsible  or  creditable.  If  the  buyer  takes  the  discount,  the  amount 
goes  to  his  account  on  the  seller's  books  and  to  the  seller's  account 
on  the  buyer's  books ;  if  he  does  not  take  it,  the  discount  may  be  en- 
tered to  Neglected  Discounts  on  the  buyer's  books  and  to  Collected 
Discounts  on  the  seller's  books.  In  case  of  an  alternative  discount, 
such  as  6%  in  ten  days  or  5%  in  thirty  days,  if  the  5%  is  taken 
1%  is  forfeited.  This  1%  should  be  debited  by  the  paying  firm  to 
Neglected  Discounts,  the  5%  should  be  debited  to  the  selling  firm's 
account,  and  6%  should  be  credited  to  Merchandise.  Conversely, 
the  selling  firm  should  credit  Collected  Discounts  1%,  credit  the 
customer  5%,  and  debit  Merchandise  6%.  This,  it  will  be  seen,  will 
leave  Merchandise  credited  for  the  proper  amount,  will  straighten 
buyer's  and  seller's  accounts,  and  will  register  exactly  the  loss  or  gain 
from  neglect  of  discounts.  All  this  can  be  done  with  very  little  labor. 
An  illustration  of  one  method  will  be  found  in  Appendix  A,  I, 
page  374. 

//.  The  Significance  of  Proprietorship  Profits 

One  of  the  most  difficult  things  for  accounting  to  determine  is  the 
real,  or  true  net,  profit  of  a  proprietorship,  especially  a  single  pro- 
prietorship. When  partnership  agreements  specify  partners'  salaries 
and  the  rate  of  interest  to  be  allowed  on  proprietors'  investment,  the 
difficulty  is  theoretically  no  greater  than  in  corporations,  but  prac- 
tically all  proprietorship  involves  so  much  commingling  of  various 


APPLICATIONS   OF   GENERAL   PRINCIPLES  343 

elements  that  differentiation  is  largely  guesswork.  For  instance,  if 
books  are  kept  so  as  to  represent  ordinary  conditions,  the  profit 
shown  at  the  end  of  the  year  comprises  three  things  —  proprietor's 
interest,  proprietor's  salary,  proprietor's  return  for  risk.  The  matter 
is  not  simplified  by  crediting  the  proprietor,  in  advance  of  closing  the 
books,  for  interest  and  for  wages;  for  the  question  at  once  arises, 
Was  the  allowed  interest  rate  in  accordance  with  the  risks  of  the 
business  as  shown  by  the  results,  and  did  the  proprietor  earn  more  or 
less  than  was  credited  to  him?  Figuring  interest  and  wages  of 
management  at  an  arbitrary  rate  does  not  help  the  determination 
of  actual  profit. 

Every  man  can  get  interest  on  investments  (if  he  is  willing  to  accept 
a  sufficiently  low  rate),  he  can  get  something  by  working  for  another 
(if  he  will  accept  what  he  can  convince  others  that  he  will  be  worth 
to  them),  and  he  can  get  compensation  for  risks  taken  (if  he  is  willing 
and  able  to  take  a  sufficient  number  of  risks  to  get  a  fair  average). 
So  interest  and  salary  and  return  for  risk  are  not  peculiar  to  pro- 
prietorship. A  man  wishes  to  know,  then,  how  much  he  gets  out  of 
his  proprietorship  that  he  probably  would  not  get  otherwise.  What 
he  gets  —  as,  for  instance,  a  sense  of  independence  —  may  not  be 
calculable  in  dollars ;  but  it  is  at  least  interesting  to  know  how  much 
in  dollars  it  costs.  The  possibilities  for  a  proprietor  that  a  salaried 
man  lacks,  of  course,  are  the  opportunity  to  make  what  he  is  worth 
—  and  not  merely  what  somebody  else  thinks  he  is  worth,  —  and  to 
take  for  himself  the  chances  that  are  continually  occurring ;  but  the 
possibihties  are  also,  of  course,  to  earn  less  than  he  might  be  worth 
to  some  one  else,  and  to  lose  by  the  ever-recurring  turns  of  chance. 
How  shall  he  measure  the  difference  in  income  between  a  proprietor- 
ship (using  the  word  in  the  sense  of  a  managing  ownership)  and  de- 
pendence or  retirement? 

The  approach  to  a  solution  —  and  an  absolute  solution  is  impos- 
sible, for  no  one  can  tell  exactly  what  might  have  been  —  is  to  divide 
the  total  profit  as  closely  as  possible  into  its  three  parts  —  interest, 
salary,  return  for  risk.  It  happens  that  in  the  ordinary  usage  of  the 
word  '"interest"  the  element  of  risk  is  included;  for  different  rates 
of  interest  are  paid  on  loans  largely  because  of  the  differing  elements 
of  risk.  For  our  purposes  here,  therefore,  we  must  distinguish  be- 
tween pure  interest  and  common  interest  —  not  in  criticism  of  the 


344  ACCOUNTS 

ordinary  use  of  the  word  but  merely  to  get  out  of  its  meaning  an  ele- 
ment that  we  wish  to  provide  for  elsewhere.  The  pure  interest  rate, 
with  practically  all  risk  ehminated,  is  found  in  the  business  world 
as  the  rate  on  national  government  loans,  for  here  there  is  no  risk. 
This  rate  is  a  matter  of  common  report  (though  variations  from  it  in 
the  case  of  bond  issues  specially  in  demand  as  security  for  bank-note 
circulation,  etc.,  must  not  be  confused  with  it),  and  it  can  therefore 
furnish  us  a  starting-point.  We  know  that  the  proprietor's  capital 
could  earn  this  rate,  without  risk,  if  it  had  not  been  invested  in  the 
business.  Then  this  rate  applied  to  the  proprietor's  average  invest- 
ment for  the  year  is  a  cost  of  doing  business,  and  no  profit  is  net  until 
this  has  been  subtracted  from  income.  If  this  is  to  be  entered  on  the 
books,  as  may  be  desirable,  it  should  have  an  account  by  itself,  for 
since  it  is  pure  interest  it  is  unlike  what  is  represented  in  other  in- 
terest accounts. 

We  have  remaining,  then,  proprietor's  salary  and  return  for  risk, 
—  the  latter  of  which  we  may  call  the  fortuitous  element.  Neither 
can  be  quite  determined  independently  of  the  other,  and  so  they 
must  be  taken  in  a  sort  of  seesaw  relation.  Our  problem  would  be 
simple  subtraction  if  we  could  determine  either  of  these  independent 
of  the  other.  Yet  we  can  find  a  few  suggestions  for  each  independ- 
ently. An  indication  of  manager's  salary  may  be  found  in  what  he 
has  received,  in  what  he  has  been  offered,  in  what  other  men  ap- 
parently in  the  same  class  are  getting ;  yet  none  of  these  is  necessarily 
a  sound  criterion,  for  a  man's  value  changes  both  with  his  oppor- 
tunities and  independently  of  them,  and  men  apparently  of  the  same 
class  are  often  thoroughly  unlike.  Similarly,  an  indication  of  return 
for  risk  lies  in  the  interest  rate  for  loans  under  apparently  like  con- 
ditions; though  conditions  apparently  alike  are  often  diverse.  The 
point  is  that  if  a  man  is  in  business  for  himself,  he  should  know  that 
he  is  losing  money  unless  he  can  earn  the  pure  interest  rate,  plus  as 
much  salary  as  he  would  probably  get  outside,  plus  compensation 
for  the  risks  taken.  If  a  series  of  years  shows  a  failure  to  accomplish 
this  when  no  external  cause  can  be  found  in  bad  conditions  (Hke 
bad  markets),  the  presumption  is  that  he  as  a  manager  is  not  worth 
the  salary  he  has  set  for  himself.  He  should  reduce  his  salary  credit 
on  the  books.  If,  again,  conditions  have  been  steady  and  the  sum  of 
his  salary  and  return  for  risk  is  in  a  series  of  years  rising,  he  may 


APPLICATIONS  OF  GENERAL  PRINCIPLES  345 

properly  credit  himself  for  the  increase.  Loss  caused  by  a  known 
error  in  management  should  be  taken  out  of  the  salary  share  and  not 
attributed  to  chance.  If  conditions  have  been  steady,  and,  though  he 
can  find  no  error  in  management,  the  sum  of  these  two  elements  is  in 
one  year  smaller  than  usual,  the  shrinkage  may  be  properly  taken 
from  the  risk  element,  as  one  of  the  turns  of  chance.  If,  on  the  other 
hand,  conditions  have  been  unusually  favorable  to  profits,  the  return 
for  risk,  as  a  fund  accumulated  in  good  years  for  store  against  the 
lean  years,  should  be  high ;  and  if  profits  are  not  actually  high,  the 
credit  for  salary  should  be  reduced. 

Very  commonly  all  this  attempt  at  dividing  an  indivisible  sum 
would  not  be  worth  while.  It  would  never  be  thought  worth  while 
by  the  man  who  cares  only  for  the  amount  of  his  gross  profits  ir- 
respective of  their  source.  The  result  of  it  all,  under  favorable  oppor- 
tunities for  division,  is  to  show  a  proprietor  the  maximum  that  he 
can  have  made  by  being  in  business  for  himself.  Some  men  are 
naturally  lucky,  —  and  luck  sometimes  falls  to  retired  investors,  to 
employees,  and  to  speculators,  as  well  as  to  managing  proprietors. 
Though  the  average  return  to  investment  is  about  the  government 
rate  (taking  into  account  losses  of  capital  as  well  as  of  interest), 
many  men  are  lucky  enough  to  get  more,  —  often,  however,  what  is 
called  luck  is  but  good  management.  Some  employees  are  able  to 
impress  their  worth  upon  employers  far  more  than  others  of  more 
worth.  Some  speculators  are  able  by  pure  chance  to  get  more  than 
adequate  return  for  the  risks  that  they  take.  A  proprietor,  then, 
must  get  out  of  his  business  at  least  enough  to  make  his  chances  as 
good  as  they  would  be  if  he  were  to  give  up  his  business.  Of  what  has 
been  called  the  fortuitous  element  he  must  get  in  good  years  enough 
to  offset  the  danger  of  failure  to  get  in  bad  years  the  minimum  of 
government  interest  and  manager's  salary.  Even  a  high  fortuitous 
element  of  profit  does  not  necessarily  measure  his  gain  above  the 
average  by  being  in  business  for  himself.  In  ordinary  years  some 
fortuitous  element  must  be  earned,  or  the  risks  will  not  be  paid  for. 
Any  excess  of  this  above  the  normal  means  only  that  his  gain  by 
being  in  business  for  himself  is  no  more  than  that  excess.  How  much 
more  or  less  than  the  average  his  gain  might  have  been  if  he  had  not 
been  in  business  no  one  can  tell.  The  question  with  him  is  whether 
this  known  maximum  is  enough  to  make  his  business  career  worth 


346  ACCOUNTS 

while,  —  and,  as  has  been  akeady  suggested,  many  elements  besides 
dollars  and  cents  may  enter  into  the  equation. 

///.  A  Basis  jor  Consolidations 

In  Chapter  IX  a  study  was  made  of  the  comparative  earnings  and 
solvency  of  two  corporations  and  a  proprietorship.  In  any  plan  for 
combination,  an  analysis  of  the  affairs  of  each  concern  should  be 
made  on  the  principles  applied  in  that  chapter.  Of  course  actual 
access  to  the  books  may  be  fairly  demanded  after  the  negotiations 
have  passed  the  preliminary  stages,  and  then,  if  the  accounting  of 
any  concern  seems  defective,  new  income  sheets  and  balance  sheets 
may  be  constructed  and  used  as  a  basis  for  the  plan. 

It  is  common  to  read  that  balance  sheets  are  of  little  use  in  judging 
the  value  of  a  going  concern,  for  earning  capacity  is  what  really 
counts  and  that  is  shown  only  by  the  income  sheet.  To  great  extent 
this  is  true,  but  in  a  merger  a  disregard  of  balance  sheets  could 
easily  lead  to  absurdity.  Though  earning  capacity  is  dependent 
quite  as  much  on  intangible  things,  like  personality  and  good  will, 
as  upon  physical  property,  these  intangible  things  can  produce  no 
results  in  business  without  the  physical  property  to  work  upon.  In 
a  merger,  therefore,  consideration  may  well  be  given  not  only  to  the 
intangible  things  which  show  their  results  on  the  income  sheet,  but 
also  to  the  media  through  which  these  intangible  things  may  work,  as 
shown  on  the  balance  sheet.  To  express  the  thing  more  concretely, 
the  combination  desires  to  secure  not  only  the  good  reputation, 
the  good  trade,  and  the  good  management,  of  the  separate  concerns, 
but  also  goods  (or  machinery),  and  facilities,  and  equipment.  Even 
though  one  of  the  combining  concerns  has  not  made  the  best  use  of 
its  physical  property,  and  so  has  earned  little  with  it,  the  improved 
management  of  the  combination  should  be  able  to  do  as  much  with 
that  property,  dollar  for  dollar,  as  with  any  other.  If  the  improved 
management  cannot  do  so,  the  property  is  clearly  overvalued,  and 
the  revised  balance  sheet  should  reduce  the  valuation.  In  the  mer- 
ger, therefore,  the  actual  worth  of  the  net  assets  of  all  members  of 
the  combination  should  be  given  equal  weight,  and  a  portion  of  the 
capital  stock  should  be  distributed  on  that  basis  alone.  When  the 
amount  of  stock  to  be  distributed  on  that  basis  has  been  determined, 
the  rest  may  be  apportioned  on  the  basis  of  the  excess  of  earning 


APPLICATIONS  OF  GENERAL  PRINCIPLES  347 

capacity  over  the  normal  income  for  that  amount  of  assets,  —  or 
the  annual  value  of  what  is  commonly  called  the  good  will/ 

Doubtless  no  two  persons  would  offer  quite  the  same  plan  for  any 
consolidation;  for  no  two  would  put  quite  the  same  valuation  on 
assets  or  estimate  future  earnings  in  quite  the  same  way.  An  ac- 
cepted scheme  is  the  result  of  compromise.  Usually  the  weakest 
member  of  the  combination  makes  the  most  sacrifices;  but  some- 
times, because  its  weakness  makes  it  an  element  of  danger,  it  must 
be  offered  heavy  inducements  to  accept  the  plan. 

The  plan  outlined  above  may  be  worked  out  on  the  following 
suppositions : 

Percentage  Excess  over  Annual  Good 

Earnings  6^  Will 

6  o 

12  6  3,000 

24  18  4>5oo 

$175,000  $18,000  $7,500 

In  this  case,  since  the  total  earnings  are  $18,000,  the  capitalization 
of  the  combination  at  6%  would  be  $300,000.  Of  this,  $175,000 
would  be  distributed  on  the  basis  of  assets;  and  $125,000  would  be 
apportioned  on  the  basis  of  good  will,  and  f  f  of  it  would  go  to  B  Co. 
and  1^1  to  C.  D.   The  ultimate  facts,  then,  would  be  as  follows: 


Net  Average 

Earnings 

Assets,  1907 

1907 

A  Co. 

$100,000 

$6,000 

B  Co. 

50,000 

6,000 

C.  D. 

25,000 

6,000 

Stock  for  Assets 

Stock  for  Good  Will 

Total  Stock 

A  Co. 

$100,000 

$100,000 

B  Co. 

50,000 

$50,000 

100,000 

C.  D. 

25,000 

75,000 

100,000 

$175,000  $125,000  $300,000 

This  distribution,  if  the  earnings  are  the  same  as  before,  and  the 
same  as  expected,  will  give  each  the  same  income  as  before,  $6000. 

It  is  now  interesting  to  note  that  a  distribution  of  capital  stock  on 
the  basis  of  earning  capacity  only  would  have  produced  the  same 

^  The  significance  of  the  expression  "good  will"  is  more  comprehensively  shown 
in  Appendix  B,  I,  p.  405.  The  annual  value  here  is  simply  what  is  produced  by  the 
business  above  the  normal  rate  of  interest  on  the  capital  invested.  It  should  be  noted, 
of  course,  that  for  determining  earning  capacity  the  assets  to  be  compared  with  the 
earnings  are  not  necessarily  the  assets  at  the  end  of  the  year,  but  the  average  net  assets 
for  the  whole  year,  —  really  the  average  net  capital. 


348  ACCOUNTS 

result,  i.  e.,  y\  oi  $300,000  to  each.  Under  the  other  plan,  the 
extra  sum  which  was  given  to  one  concern  because  of  its  assets  was 
exactly  counterbalanced  by  the  extra  sum  given  to  another  concern 
because  of  its  extra  earning  capacity.  The  smallness  of  the  assets, 
when  the  earnings  are  fixed,  is  a  measure  of  the  excess  of  earning 
capacity.  So  the  two  methods  —  one  allowing  for  assets,  and  the 
other  disregarding  them  —  produce  the  same  results  in  this  sort 
of  case. 

The  moment  we  introduce  the  new  element  of  expected  increase 
in  profits  from  the  combination,  however,  the  two  methods  diverge 
in  results.  On  what  basis  shall  the  expected  increase  of  profits  be 
distributed  ?  The  answer  must  depend  largely  on  the  expected  source 
of  those  profits.  If  the  increase  is  to  come  chiefly  from  an  increase 
of  assets,  assets  should  be  the  chief  basis.  If  it  is  to  come  chiefly 
from  the  application  of  the  reputation  and  the  executive  organiza- 
tion and  the  personnel  of  the  better  concerns  to  the  assets  of  the 
poorer,  earning  capacity  chiefly  should  govern ;  but  the  measure  of 
earning  capacity  for  this  purpose  is  really  the  good  will,  i.  e.,  the 
capacity  to  earn  greater  than  ordinary  profits.  Let  us  try  these  cases 
and  compare  results  with  the  distribution  on  the  basis  of  earning 
capacity  only. 

Suppose  the  expectation  is  that  earnings  will  increase  one  third, 
or  to  $24,000.  This,  at  6%,  would  justify  a  capitalization  of  $400,- 
000  (leaving  out,  for  the  sake  of  simplicity,  any  margin  for  safety). 
On  a  basis  of  simple  earning  capacity,  this  would  give  to  each 
concern  capital  stock  to  the  amount  of  $133,333-33  5  ^^r  as  their  pre- 
vious earnings  were  each  $6000  out  of  $18,000,  each  would  be  en- 
titled to  one  third  the  issue  of  $400,000.  When  we  make  separation 
between  the  claims  on  account  of  assets  and  on  account  of  good 
will,  however,  we  find  far  other  figures.  If  we  assume  the  increase 
to  be  due  to  the  good  management  of  the  better  concerns  extending 
over  the  poorer,  we  distribute  the  stock,  above  the  requirement  to 
cover  assets,  on  the  basis  of  the  measure  of  that  good  management, 
namely,  the  excess  profit  or  good  will  of  those  concerns.  This  works 
out  as  follows: 


APPLICATIONS   OF   GENERAL  PRINCIPLES  349 

Stock  for  Annual  Good          Share  of  Stock  for  Total 

Assets  Will,  as  before  $225,000  Stock  Good  Will  Stock 

A  Co.       $100,000  $100,000 

B  Co.          50,000  $3,000                    %  $90,000  140,000 

C.  D.           25,000  4,500                    f  135,000  160,000 

$175,000  $7,500  $225,000         $400,000 

If  we  assume  the  gain  from  combination  to  arise  from  the  increase 
in  assets,  the  share  for  good  will  remains  as  in  the  first  case,  and  the 
rest  is  distributed  in  the  proportion  of  the  assets  of  each,  —  i.  e., 
$125,000  for  good  will  and  $275,000  for  assets,  as  follows: 


Assets 

Annual 

Stock  for 

Share  of         Stock  for 

Total 

Good  Will 

Good  Will 

Stock  for  Assets     Assets 

Stock 

A  Co. 

$100,000 

\n       $157,144 

$157,144 

B  Co. 

50,000 

$3,000 

$50,000 

tS%                I^Sl^ 

128,571 

C.  D. 

25,000 

4,500 

75,000 

^%               39,285 

114,285 

$175,000      $7,500       $125,000  $275,000     $400,000 

The  last  two  cases,  as  compared  with  distribution  on  the  basis 
of  earning  capacity  alone,  show  that  only  by  a  separation  between 
assets  and  good  will  is  it  possible  to  approximate  a  fair  basis  for 
apportionment, — or  at  any  rate  one  that  shall  be  satisfying.  Any 
degree  of  variation  may  be  made,  and  all  on  a  scientific  principle; 
for  agreement  may  be  made  in  advance  as  to  how  much  of  the  stock 
issued  for  expected  increase  in  earnings  shall  be  distributed  on  the 
basis  of  assets  and  how  much  on  the  basis  of  good  will.  It  may  in- 
deed happen  that  under  such  an  arrangement  a  concern  with  heavy 
assets  but  low  earnings  may  be  forced  to  sacrifice  on  its  share  of 
stock  distributed  for  assets  in  order  to  compensate  the  others  for 
its  low  earning  capacity,  —  or,  more  exactly,  for  the  opportunity 
to  share  in  their  high  earning  capacity;  but  such  allowances  intro- 
duce no  complications. 

It  is  now  interesting  to  see  how  the  three  distributions  of  stock 
as  applied  above  affect  the  income  of  these  three  concerns,  assuming 
the  expected  earnings  to  be  realized  by  the  combination. 


3  so 

ACCOUNTS 

On  Basis  of  Earning  Capacity 

Combined  Basis  chiefly  Good 
WiU 

Combined  Basis  chiefly 
Assets 

Income 

Increase 

Income 

Increase 

Income 

Increase 

A  Co.    $8,000 

$2,000 

$6,000 

$9,429 

$3,429 

B  Co.      8,000 

2,000 

8,400 

2,400 

7,714 

1,714 

C.  D.      8,000 

2,000 

9,600 

3,600 

6,857 

857 

In  all  cases  except  one,  some  benefit  is  derived  from  entering 
the  combination ;  in  that  exception,  benefit  might  consist  in  security 
for  an  income  precarious  outside  the  combination. 

It  should  be  noted  that  in  these  cases  of  a  divided  basis,  some  for 
assets  and  some  for  good  will,  we  have  given  assets  a  larger  share 
than  may  appear,  for  the  amount  of  good  will  is  itself  affected  by 
the  assets.  A  firm  with  $50,000  capital  earning  10%  would  have 
a  larger  good  will  than  one  with  $25,000  capital  earning  10%,  for, 
using  6%  as  a  basis  return,  the  first  would  have  a  good  will  of  $2000 
and  the  second  of  only  $1000  (4%  on  $50,000,  and  4%  on  $25,000). 
This  method  then  coimts  assets  twice  —  once  in  direct  share  of 
stock  for  assets,  and  once  in  the  influence  of  assets  on  good  will.  If 
it  is  desired  to  prevent  this  and  put  more  emphasis  on  good  will, 
the  distribution  of  stock  for  good  will  should  be  not  on  the  basis 
of  absolute  annual  good  will  (that  is,  the  amount  of  such  good  will, 
as  applied  above),  but  on  the  percentage  of  good  will.  In  the  case 
just  cited,  both  the  $50,000  firm  and  the  $25,000  firm  had  earnings 
of  four  per  cent  above  the  basis:  considering  what  they  had  to 
work  with,  they  are  on  a  parity,  and  should  share  equally  in  any 
distribution  of  stock  for  good  will;  for  any  necessary  allowance  for 
difference  in  assets  is  already  made  in  the  distribution  on  the  score 
of  assets. 

These  considerations  make  it  apparent  that  any  consolidation 
which  bases  distribution  of  stock  on  any  number  of  years'  purchase 
of  the  net  profits  either  is  imscientific  or  is  merely  a  convenient 
way  of  applying  a  plan  worked  out  on  a  very  different  sort  of  cal- 
culation. To  say  as  a  general  principle  that  the  good  will  of  a  busi- 
ness is  worth  any  number  of  times  its  net  earnings  is  absurd:  one 
may  say  so  in  a  specific  case,  however,  if  one  has  previously  learned 
that  the  ratio  of  its  earnings  to  its  capital  is  such  that  its  excess 
earnings  above  the  basis  rate  on  its  capital  are  enough  to  warrant 
that  number  of  years'  purchase;  but  many  businesses  have  no  good 


I 


APPLICATIONS  OF   GENERAL   PRINCIPLES  351 

will,  in  spite  of  large  earnings,  for  these  earnings  are  below  the  nor- 
mal return  on  the  capital.  When,  however,  the  interested  parties 
have  worked  out  an  analysis  of  capital  and  earnings,  as  above,  and 
have  settled  on  the  plan  of  distribution,  the  arrangement  may  often 
be  conveniently  expressed  in  terms  of  years'  purchase  of  net  earn- 
ings; but  there  is  no  necessary  relation  between  net  earnings  (in- 
dependent of  capital)  and  good  will;  the  relation  is  between  excess 
earnings  (above  a  basis  rate)  and  good  will.  The  basis  rate,  of 
course,  may  be  whatever  one  likes;  but  the  higher  the  rate  the 
lower  the  good  will  and  the  lower  the  capitalization. 


CHAPTER  TWENTY-TWO 

SETTLEMENTS— TRUSTEESfflP,  PARTNERSHIP,  BANKRUPTCY 

A  FEW  matters  of  infrequent  occurrence  in  any  business  but  of 
great  importance  when  they  occur  should  be  discussed  briefly. 
Such  are  trusteeships,  partnership  settlements,  and  bankruptcy 
settlements.  The  general  principles  of  accounting  should  be  ade- 
quate for  guidance  in  most  matters  relating  to  these  circumstances; 
but  certain  cautions  and  technical  conveniences  are  worth  noting. 

Regarding  trusteeship  settlements  (which  for  this  purpose  may 
be  taken  to  include  executorships  and  administratorships),  the 
first  caution  is  that  no  confusion  be  allowed  between  principal  and 
income.  Everything  belonging  to  an  estate  at  the  decease  of  the 
owner  is  capital,  even  though  from  the  point  of  view  of  his  lifetime 
it  were  accrued  income.  Certain  claims  of  an  estate  enforceable 
months  after  decease  must  therefore  be  divided  into  that  portion 
which  had  accrued  prior  to  decease,  which  is  capital  —  or  what  is 
technically  known  as  "corpus,''  —  and  that  portion  which  has 
accrued  since  decease,  which  is  income  of  the  estate  proper.  This 
holds  true  of  such  matters  as  rents,  interest,  and  dividends  (which 
are  deemed  to  date  from  the  time  of  declaration  rather  than  that  of 
payment) .  In  some  cases  it  is  difficult  to  know  whether  the  value 
accruing  is  capital  or  revenue,  as  when  a  stock  or  extra  dividend 
has  been  declared.  These  cases  require  separate  investigation,  and 
are  too  much  involved  for  discussion  in  a  general  treatise  of  this 
sort. 

Regarding  partnership  settlements,  it  is  of  the  utmost  impor- 
tance to  realize  that  partners  often  have  other  relations  with  the 
firm  than  those  of  capital.  A  partner  may  be  allowed  salary,  and 
interest  on  his  investment,  and  accumulated  profits,  he  may  be  al- 
lowed withdrawals,  and  he  may  have  made  loans.  The  partnership 
agreement  should  be  so  drawn  that  every  one  concerned  can  know 
exactly  what  relation  these  various  connections  with  the  business 
bear  to  his  capital  and  to  his  profits.  Such  questions  as  these  often 


TRUSTEESHIP,  PARTNERSHIP,  BANKRUPTCY         353 

arise  in  making  settlements:  Is  undrawn  salary  to  be  treated  as 
capital  and  share  in  profits?  If  interest  is  allowed  on  capital,  is  it 
to  be  allowed  on  undrawn  salaries?  If  interest  is  debited  to  part- 
ners for  deficiencies  in  investment,  is  that  interest  to  be  credited 
to  the  general  interest  account,  giving  a  profit  to  the  business  (in 
which  the  partner  is  to  share  as  in  other  profits),  or  is  it  to  be  cred- 
ited directly  to  the  other  partners?  A  partner's  loan  to  a  business 
must  be  clearly  distinguished  from  his  investment  of  capital;  for, 
first,  if  profits  are  to  be  distributed  on  the  basis  of  investment, 
loans  should  not  be  counted  in  the  basis  of  distribution;  and,  sec- 
ondly, in  case  of  bankruptcy  or  assessment,  loans  may  be  can- 
celed against  assessment  and  should  not  share  in  losses  —  imless 
the  other  partners  are  unable  to  bear  their  shares  of  the  deficiency 
and  therefore  the  lending  partner  must  make  up  the  default  of  the 
others.  In  case  of  dissolution,  if  assets  are  realized  not  all  at  once 
but  in  instalments,  and  provision  is  made  for  their  distribution  as 
they  are  realized,  care  must  be  taken  to  see  that  no  partner  shares 
in  these  assets  imtil  other  partners  have  been  paid  out  of  assets 
enough  to  bring  their  shares  of  loss,  in  case  no  more  assets  are  real- 
ized, down  to  their  due  proportion  of  loss.  This  needs  illustration. 
Suppose  A,  B,  and  C  have  invested  $60,000,  $40,000,  and  $20,000, 
respectively,  but,  because  of  supposed  differences  in  ability  or  ex- 
perience or  personal  following,  they  are  to  share  profits  and  losses 
equally  in  spite  of  differences  in  investment.  Let  us  now  suppose 
that  the  business  is  unprofitable  and  is  in  process  of  liquidation, 
and  that  a  realization  of  $20,000  on  assets  is  to  be  dispensed.  To 
be  on  the  safe  side,  this  should  be  dispensed  as  if  no  more  assets 
would  be  realized.  This  last  condition  would  involve  a  total  loss  of 
$100,000,  or  $S3^333  ^^^  ^^^^  partner.  Then  no  part  of  the  $20,000 
can  go  to  any  partner  until  the  other  partners  have  received  enough 
distribution  to  reduce  their  losses  to  an  equality  with  the  partner 
in  question.  Here,  if  Partner  A  is  given  the  whole  $20,000  his  net 
loss  of  capital,  assuming  that  no  more  is  ever  realized,  will  be  no 
less  than  B's,  and  will  be  more  than  C's.  So  he  will  get  it  all.  Then, 
as  A  and  B  are  now  on  an  equality,  they  should  share  in  further 
realizations  imtil  their  possible  losses  are  reduced  to  the  level  of  C's. 
Not  imtil  total  realization  has  exceeded  $60,000,  giving  a  net  loss 
less  than  $60,000,  or  $20,000  for  each  partner,  will  C  get  anything 


354  ACCOUNTS 

from  realizations  —  for  his  possible  loss,  unless  he  is  called  upon 
for  assessments,  is  limited  to  his  $20,000  invested. 

All  such  adjustments  can  be  adequately  made  if,  in  the  first  place, 
the  partnership  agreement  states  clearly  each  partner's  financial 
duties  and  privileges,  and,  in  the  second  place,  the  books  are  so 
kept  that  each  partner's  relations  with  the  business  are  clearly 
shown  in  their  various  aspects  —  capital  investment,  salary  allowed 
and  drawn,  interest  allowed  and  charged,  profits  and  losses  shared, 
and  loans. 

Regarding  settlements  in  doubtful  solvency,  the  chief  peculiar- 
ities relate  to  the  preparation  of  statements  that  shall  show  to  all 
interested  parties,  such  as  partners,  stockholders,  and  creditors, 
the  probability  of  final  payment  of  all  obligations,  the  probability 
of  payment  of  specific  obligations,  and  the  causes  of  such  insol- 
vency as  may  finally  result.  For  these  purposes,  three  separate 
statements  are  likely  to  be  of  service.  The  first,  the  "statement 
of  affairs,"  shows  not  only  the  probable  realizable  value  of  the 
specific  assets  but  also  the  specific  liabilities  to  which  those  assets 
will  be  applied.  The  second,  commonly  called  the  "realization  and 
liquidation  statement,"  shows  in  brief  form  the  results  of  the  oper- 
ations of  the  liquidators  —  and  hence,  when  compared  with  the 
statement  of  affairs,  shows  how  accurate  or  inaccurate  was  the 
estimate  incorporated  in  that  statement.  The  last,  the  "deficiency 
statement,"  shows  the  causes  of  the  insolvency,  with  an  indication 
of  the  ownership  of  the  property  lost.  When  there  is  no  insolvency 
there  is  no  deficiency,  for  the  capital  is  adequate  to  pay  the  debts. 

The  statement  of  affairs,  it  will  be  observed,  begins  with  liabil- 
ities and  divides  them  into  various  groups,  according  to  the  sort 
of  assurance  of  payment,  and  then  subtracts  from  those  liabilities 
the  value  of  any  assets  clearly  available  for  meeting  them.  Ulti- 
mately, therefore,  only  the  unsecured  debts  remain  as  the  total  of 
this  side  of  the  statement.  On  the  other  side,  similarly,  the  assets 
not  pledged  for  the  payment  of  specific  liabilities  are  listed  for  the 
ultimate  payment  of  unsecured  liabilities,  A  comparison  of  the 
final  totals  of  the  two  sides  shows  the  final  estimated  deficiency, 
and  therefore  suggests  the  probable  percentage  to  be  paid  in  a 
composition  with  creditors.  The  appearance  of  a  statement  of 
affairs,  therefore,  is  unlike  that  of  a  balance  sheet,  for  the  state- 


TRUSTEESHIP,   PARTNERSHIP,   BANKRUPTCY        355 

ment  of  affairs  cancels  items  of  one  side  against  those  of  the  other 
as  far  as  such  cancelation  is  legally  possible. 

We  may  illustrate  this  by  beginning  with  a  balance  sheet  and 
working  through  to  the  deficiency  statement.  The  balance  sheet 
of  the  Roseate  Company  is  as  follows: 


I. 

Cash 

$  1,510 

IS- 

Capital  Stock 

$IOO,OOC 

2. 

Notes  Receivable 

10,140 

16. 

Notes  Payable 

30,000 

3. 

Accounts  Receivable 

19,740 

17. 

Accounts  Payable 

65,460 

4. 

Raw  ^Material 

14,200 

18. 

Bonds 

80,000 

5. 

Goods  in  Process 

7,300 

19. 

Accrued  Taxes 

1,400 

6. 

Finished  Goods 

14,000 

20. 

Accrued  Wages 

1,100 

7- 

SuppHes 

300 

21. 

Accrued  Interest 

2,700 

8. 

Real  Estate 

90,000 

22. 

Notes  Discounted 

8,140 

9- 

Machinery 

50,000 

^Z- 

Allowance  for  Depre- 

10. 

Tools 

6,000 

ciation  of  Real  Es- 

II. 

Boats 

9,000 

tate 

q,ooo 

12. 

DeUvery  Equipment 

3,000 

24. 

Allowance  for  Depreci- 

13- 

Fixtures 

1,600 

ation  of  Machinery 

5,00c 

14. 

Profit  and  Loss 

72,010 
$298,800 

$298,800 

Items  18  and  21  are  secured  by  a  mortgage  on  item  8.  There  are 
additional  mortgages,  not  on  the  books,  given  to  secure  accounts 
payable,  for  $35,000  on  item  9,  and  for  $10,000  on  items  11  and  12 
together.  On  the  attempt  to  learn  the  condition  of  affairs,  the 
realizable  values  of  the  property  are  found  as  follows:  the  real  es- 
tate is  not  overvalued,  and  the  mortgagees  will  take  it  at  its  book 
value;  the  machinery  is  worth  $30,000,  and  the  best  disposition 
of  it  seems  to  be  the  acceptance  of  an  offer  of  the  mortgagees  to 
take  it  at  that  figure;  the  best  disposition  of  the  boats  and  deHvery 
equipment  seems  to  be  acceptance  of  an  offer  of  the  mortgagees  to 
take  them  in  full  discharge  of  the  debt  of  $10,000;  the  notes  re- 
ceivable held  are  all  good,  but  the  discounted  notes  have  been  de- 
faulted and  as  the  makers  have  no  assets  the  endorsers  must  re- 
deem them;  of  the  accounts  receivable  all  but  $1,840  are  good,  but 
of  this  amount  $840  is  worthless  and  $1000  is  probably  worth  50%; 
items  4,  5,  6,  7,  10,  13  are  worth  $33,500  altogether. 

If  we  now  attempt  to  present  a  statement  of  affairs,  we  must 
estimate  the  cost  of  liquidation.  If  we  suppose  this  to  be  $1000, 
we  shall  have  the  following  figures: 


3S6 


ACCOUNTS 


Statement  of  Affairs 
Liabilities  to  be  met 


Creditors  wholly  secured 
Bonds  $80,000 
Accrued  interest  2,700 
Less 
Real  Estate,  mortgaged  as  se- 
curity 90,000 
Less  Allow,  for  Depreciation  5,000 
Value  $85,000 
Required  82,700 
Balance,  carried  to  assets,  contra  $2,300 

Creditors  partly  secured 
Accounts  Payable 
Less 
Machinery,  mortgaged  as  se- 
curity $50,000 
Less  Allow,  for  Depreciation        5,000 

$45,000 
Mortgage  claim  $35,000 


Value 
Boats,  mortgaged  as  security         $9,000 
Deliv.  Equip.,  mortg.  as  security     3,000 

$12,000 


Mortgage  claim  $10,000 

Value  of  boats,  and  deliv.  equip. 

Total  secured 

Balance  of  general  claim 


Creditors  unsecured 
Notes  Payable 
Notes  Discounted  endorsements 

Preferred  claims 
Taxes 
Wages 
Expense  of  liquidation 

Deducted  from  assets,  contra 


$30,000 


10,000 

40,000 

25460 

$65,460 


$1,400 
1,100 
1,000 

$3,500 


Book  lia- 
bilities 


Claim  on 
general 
assets 


$82,700   $  0,000 


65,460 


30,000 
8,140 


2,500 


25,460 


38,140 


0,000 


$188,800  1  $63,600 


*  This  total,  with  the  capital  stock,  $100,000,  and  the  two  allowances,  of  $5000  each  —  which  do  not 
appear  here,  —  make  up  the  $298,800  of  the  balance  sheet.  (Such  a  note  as  this  should  be  appended  to  the 
statement  of  affairs,  as  a  proof  of  its  reconciliation  with  the  books.] 


TRUSTEESHIP,   PARTNERSHIP,   BANKRUPTCY        357 


Assets  for  meeting  liabilities 

Book 
value 


I 


Cash 

Notes  Receivable,  good 
bad 

Total 
Less 
Preferred  claims 
On  books 
Taxes 
"Wages 

Not  on  books 
Est.    exp.    of 
liquidation 


$  1,510 
2,000 
8,140 


1,400 

1,100 

$2,500 


1,000 


I 


$11,650 


Balance  unapplied 

$3,500 

8,150 

$11,650 

Accounts  Receivable 
good 
doubtful 
bad 

$17,900 
1,000 

840 

$19,740 

19,740 

Real  Estate 
Less  book  items 
Allowance  for  De- 

90,000 

preciation 
Bonds  (mortgage) 
Interest  (mortgage) 

$  5,000 

80,000 

2,700 

87,700 

Balance  unapplied 

2,300 
$90,000 

Machinery 
Less  book  items 
Allowance  for  De- 

50,000 

preciation 
Accounts  Payable 
mortgage  appli- 
cable 

$  5,000 
30,000 

35,000 

Balance  unapplied 

15,000 

Net 

book 
value  ^ 


$  9,150 


19,740 


2,300 


15,000 


Estimated 

realizable 

unpledged 

value 


$10 


17,900 
500 

0,000 


2,300 


0,000 


$50,000 


Carried  over 


$171,390       $46,190      $20,710 


i  These  are  book  values  less  any  offsetting  items  actually  on  the  books  —  either  items  to  which  the 
must  be  specifically  applied,  or  items  reducing  the  assets. 


358 

ACCOUNTS 

Brought  over 

$171,390 

Boats 

$9,000 

Delivery  Equipment 

3,000 

12,000 

Less  Accounts  Pay- 

[           able     mortgage 

applicable 

$10,000 

Balance  unapplied 

2,000 
$12,000 

Raw  Material 

14,200 

Goods  in  Process 

7,300 

Finished  Goods 

14,000 

Supplies 

300 

Tools 

6,000 

Fixtures 

1,600 
$226,790 

Deficiency,  14.8% 

$46,190      $20710 


2,000  0,000 


43,400 
$91,5902 

33,500 

$54,210  2 

9,390 
$63,600 

»  This  total,  with  the  deficit,  $72,010  —  which  does  not  appear  here,  —  makes  up  the  $298,800  of  the 
balance  sheet. 

*  The  difference  between  these  two  columns  gives  the  estimated  shrinkage  of  assets  in  the  process  0! 
liquidation,  or  $37,380,  including  expenses  of  liquidation  and  loss  on  endorsements.  If  such  secured  items 
not  on  the  books  are  numerous,  they  may  well  be  given  a  special  column,  so  as  not  to  confuse  the  relation 
of  this  statement  and  the  balance  sheet;  in  finding  the  amount  which,  when  subtracted  from  the  net  book 
value,  will  give  the  measure  of  shrinkage  of  assets,  one  would  then  add  the  total  of  that  special  column  to 
the  total  of  the  estimated  value;  for  a  loss  due  to  expenses  is  not  to  be  confused  with  a  loss  on  realization. 

It  is  well  to  have  record  of  the  results  of  the  process  of  liquida- 
tion, for  such  process  usually  results  in  losses  that  would  not  occur 
if  the  business  were  to  continue  its  normal  course.  It  is  common  to 
open  an  account  with  the  title  *' Realization  and  Liquidation." 
This  account  is  debited  for  assets  to  be  realized,  for  expenses  of 
liquidation,  and  for  the  payment  of  debts  to  be  liquidated;  and  it 
is  credited  for  receipts  from  realization  and  for  debts  to  be  liqui- 
dated. Much  more  convenient  is  the  separation  of  the  various  func- 
tions of  this  account  into  three  accounts  —  Realization,  Liqui- 
dation, and  Expenses  of  Liquidation;  for  the  combined  account 
lumps  things  utterly  unlike.  The  final  balance  of  the  first  will  show 
loss  or  gain  on  realization,  that  of  the  second  will  show  any  debts 
unpaid  at  the  close  of  liquidation,  and  the  balance  of  the  third  will 
show  the  costs.  Since  it  is  desirable  to  preserve  on  the  original 
books  a  record  of  the  result  of  realization  for  each  kind  of  property, 
the  accounts  for  the  liquidation  process  should  be  handled  with- 
out interfering  in  any  way  with  the  usual  accoimts;  so  the  new  ac- 
coimts  may  form  a  complete  set  virtually  independent  of  the  others. 


TRUSTEESHIP,    PARTNERSHIP,   BANKRUPTCY         359 

Since  the  new  accounts  are  to  be  independent  of  the  old,  the  setting 
up  of  the  new  account,  Realization,  to  represent  gross  assets  re- 
quires a  new  credit,  and  the  setting  up  of  the  new  account  for  Ua- 
bilities,  Liquidation,  requires  a  debit.  Since  these  are  adjustment 
items,  kept  really  for  memorandum  purposes  only  but  best  checked 
by  double-entry  methods,  we  may  provide  a  special  account,  called 
*' Adjustment,"  or  ''Settlement,"  for  taking  the  other  half  of  these 
entries.  This  Settlement  account  will  serve  as  the  connecting  link 
between  the  old  accounts  and  the  new,  and  any  balance  at  the  end 
of  the  liquidation  process  will  serve  to  close  out  both  new  and  old 
accounts,  as  we  shall  see.  For  simplicity,  so  that  we  may  check 
our  work  and  see  the  relations  exactly,  let  us  suppose  that  the 
attempt  to  realize  and  liquidate  for  the  Roseate  Company  pro- 
duces results  identical  with  the  estimates. 

Our  first  entry  will  show  the  book  value  of  the  assets  to  be  real- 
ized upon. 

Realization  $208,650 

To  Setdement  $208,650 

Book  value  of  assets  assumed  "by  the  receiver,  as  shown  by  the  state- 
ment of  afifairs,  less  allowances  for  depreciation  and  notes  discoimted. 

Settlement  $188,800 

To  Liquidation  $188,800 

Amount  of  liability  on  the  books,  as  shown  by  the  statement  of  affairs. 

Settlement  $180,410 

To  Realization  $180,410 

Proceeds  from  realization  of  assets. 

Losses  on  Endorsements  8,140 

To  Liability  on  Endorsements  8,140 

To  record  additional  liability  previously  reported  as  contingent  only.* 

Expenses  of  Liquidation  1,000 

To  Receiver  1,000 

Fees,  and  expenses  of  liquidation. 

Settlement  1,000 

To  Liquidation  1,000 

Additional  liabilities  to  be  liquidated,  as  shown  in  last  entry. 

Liquidation  180,410 

To  Settlement  180,410 

Payment  of  debts. 

*  This  appears  to  have  been  recorded  before,  as  it  was  on  the  balance  sheet;  but  there  it  was  aJso  re^ 
ported  as  an  asset,  in  the  Notes  Receivable. 

At  the  time  of  making  the  third,  the  fourth,  and  the  seventh  en- 
try above,  proper  entries  would  need  to  be  made  in  the  normal 


360  ACCOUNTS 

accounts,  —  debiting  Cash,  or  Receiver's  Cash,  and  crediting  the 
property  accounts  for  the  amount  received  on  realization,  debiting 
Bills  Discounted  and  crediting  Bills  Receivable  for  the  defaulted 
notes,  and  debiting  liability  accounts  and  crediting  Cash  for  the 
payment  of  debts.  The  Allowances  for  Depreciation  will  also  have 
been  closed  to  the  property  accounts  to  which  they  are  related.  At 
this  point,  the  only  accounts  having  balances  on  the  books  will  be 
the  following:  Capital  Stock,  Deficit,  sundry  assets  (representing 
worthless  book  values),  simdry  liabiHties  (representing  unpaid  and 
impayable  debts),  and  the  new  accounts  opened  for  Hquidation 
purposes.  Obviously,  as  already  suggested,  the  balance  of  Real- 
ization explains  the  insolvency  in  part,  the  balance  of  Losses  on 
Endorsements  and  that  of  Expenses  of  Liquidation  explain  more, 
and  that  of  Deficit  on  the  old  books  explains  the  rest.  It  is  con- 
venient to  open  an  account  with  Deficiency  to  explain  in  one  sum- 
mary statement  how  the  business  came  to  its  insolvency.  Since 
this  title  ''deficiency"  is  used  to  designate  insolvency,  as  distin- 
guished from  "deficit"  which  indicates  merely  a  loss  of  capital, 
the  account  should  not  be  used  unless  all  the  capital  has  been  ex- 
hausted and  outstanding  debts  are  left  unpaid.  Since,  in  turn,  two 
accounts,  Capital  Stock  and  Liquidation,  explain  how  the  business 
happened  to  have  so  much  property  to  lose,  we  may  well  close 
them  also  into  Deficiency.  We  may  now  make  the  entries  for  clos- 
ing our  books. 

Deficiency  $109,390 

To  Realization  $28,240  1 

Losses  from  Endorsements  8,140 

Expenses  of  Liquidation  1,000 

Deficit  72,010 

To  close  the  loss  accounts. 
Capital  Stock  $100,000 

Liquidation  9j390 

To  Deficiency  109,390 

To  close  unliquidated  balances. 

*  This  is  less  than  the  amount  shown  at  the  foot  of  the  statement  of  affairs,  for  here  the  expense  o! 
liquidation  and  the  loss  from  endorsements  are  shown  separately  —  as  they  might  have  been  shown  there. 

We  have  remaining  on  the  books  the  worthless  original  asset 
(debit)  balances,  the  unpayable  liability  (credit)  balances,  and 
Settlement.  The  first  amount  to  $28,240,  the  second  to  $9390,  or 
a  debit  balance  for  the  two  of  $18,850,  and  the  balance  of  the  last 


TRUSTEESHIP,    PARTNERSHIP,   BANKRUPTCY  361 

is  a  credit  of  $18,850.  One  entry  will  close  them  all,  but  in  practice 
it  would  be  wise  to  close  the  asset  and  the  liability  accounts  sep- 
arately. For  convenience  they  are  here  combined. 

Sundry  liabilities  $  9,390 

Settlement  18,850 

To  Sundry  assets  28,240 

To  close  worthless  asset  balances  and  liabilities  canceled  in  composition. 

Now  no  open  accounts  remain  anywhere  on  the  books.  The 
Settlement  account,  as  already  suggested,  ties  together  the  old 
accounts  and  the  new.  It  shows  ultimately  the  loss  to  creditors  by 
the  failure  of  the  business  to  pay  its  debts  in  full,  and  the  last 
entry  records  on  the  creditors'  accounts  the  fact  that  their  claims 
are  closed  only  by  an  act  of  composition  and  not  by  payment.  A 
statement  showing  in  as  much  or  as  little  detail  as  is  desired  the 
actual  processes  of  realization  and  liquidation  may  then  be  pre- 
pared from  the  ledger. 

A  deficiency  statement,  merely  giving  in  somewhat  different 
form  the  details  of  the  Deficiency  account  as  shown  by  the  journal, 
may  well  appear  as  follows : 

Deficiency  Statement 
Causes  of  deficiency 

Shrinkage  on  realization  of  assets 

Net  book  values  $83,450 

Realized  values  55>2iQ        $  28,240 

Loss  on  endorsements  8,140 

Expenses  of  liquidation  1,000 

Operating  losses  previously  reported  72,010 


$109,390 


Origin  of  property  lost 


Capital  of  proprietors  $100,000 

Liquidation  (net  insolvency)  9,390 

$109,390 


As  a  convenience  for  any  who  may  wish  to  check  these  entries 
through  the  ledger,  a  summary  ledger,  with  figures  only,  is  ap- 
pended. All  original  real  accounts,  with  any  normal  real  accounts 
opened  in  the  processes  of  liquidation,  are  here  consolidated  into 
two,  Sundry  Assets,  and  Sundry  Liabilities. 


362 

226,790 
i8o,4io  » 

Sundry  Assets 

Deficit 
Realization 

Settlement 
5ES  ON  Endorsed 

ACCOUNTS 

Sundry  Liabilities 

180,410 »                 8,140                                  188,800 

8,140                180,410                                     8,140 

180,410 »                 9,390                                    1,000 

10,000                197,940                                 197,940 
28,240               

407,200 

407,200 

72,010 

180,410 

28,240 

208,650 

208,650 
180,410 

Capital  Stock 
100,000                                  100,000 

72,010 

Allowances  for  Depreciation 
10,000                                    10,000 

208,650 

Liquidation 

180,410                                  188,800 

208,650 

188,800 

180,410 

1,000 

9,390                                    1,000 
189,800                                 189,800 

Expenses  of  Liquidation 
1,000                                     1,000 

18,850 

389,060 

Loss 
8,140 

389,060 

[ENTS 

8,140 

Deficiency 
109,390                                  109,390 

*  These  three  items  of  $180,410  each  may  not  be  obviotis.  The  first  debit  is  for  cash,  or  receiver's  cash, 
from  the  assets  realized,  and  the  first  credit  is  for  the  previous  asset  accounts  credited  or  transferred 
when  the  property  was  sold  and  the  receiver's  cash  debited.  The  second  credit  is  for  the  receiver's  cash 
disbursed  in  payment  of  sundry  liabilities.  Of  course  the  first  two  items  cancel  each  other,  but  they  are 
shown  here  for  completeness. 


I 


CHAPTER  TWENTY-THREE 
AUDITING 

AtJDiTiNG  is  undertaken  usually  for  one  or  more  of  three  purposes, 
—  to  determine  the  legality  of  transactions,  to  detect  errors  in  the 
records,  to  determine  the  correctness  of  the  conclusions  drawn  from 
the  books.  In  affairs  of  government,  the  functions  of  auditors  are 
often  separated,  one  man  passing  upon  the  legality  of  acts  and  an- 
other upon  the  accuracy  of  the  record.  Officials  performing  these 
duties  are  variously  called,  usually  either  auditor  or  controller  (or 
comptroller) ;  but  these  two  terms  are  not  consistently  discriminated. 
Usually  the  duties  of  the  legal  auditor  are  to  receive  all  claims,  com- 
pare them  with  the  provisions  of  law  under  which  they  are  made, 
and  determine  whether  warrants  upon  the  treasury  shall  be  issued. 
For  example,  municipal  bonds  are  sometimes  bad  investments  be- 
cause auditors  in  passing  upon  the  claims  of  the  bondholders  have 
discovered  that  the  bonds  were  issued  without  adequate  legal  au- 
thority. An  auditor  for  an  administrative  body  classifies  all  expendi- 
tures that  he  has  endorsed  and  keeps  complete  record  of  them  on 
the  basis  of  the  legal  warrant  rather  than  on  that  of  the  purpose 
served,  and  so,  as  already  suggested  in  another  chapter,  his  accounts 
are  largely  independent  of  the  accounts  of  heads  of  departments, 
and  may  show  an  entirely  different  set  of  figures. 

How  thorough  shall  be  an  auditor's  examination  of  books  is  a 
matter  for  agreement  between  him  and  the  persons  employing  him. 
In  case  of  an  attempt  to  learn  whether  fraud  has  been  committed, 
the  auditor  is  not  expected  to  consider  anything  about  the  books 
other  than  the  responsibility  of  the  people  suspected.  The  books 
may  be  well  or  ill  kept  so  far  as  accounting  principles  are  concerned, 
but  it  is  not  his  function  to  advise ;  though  naturally  he  would  make 
some  suggestions  as  a  matter  of  professional  interest.  If,  again, 
his  opinion  is  desired  merely  on  the  method  of  accounting,  to  learn 
whether  the  figures  have  been  correctly  interpreted  in  figuring  profit 
and  loss,  in  keeping  run  of  costs,  etc.,  he  need  add  no  columns  and 


364  ACCOUNTS 

check  no  postings.  His  business  will  be  rather  with  the  classification 
of  items  and  the  method  of  drawing  conclusions  from  the  totals. 
If,  finally,  he  is  to  report  on  the  business  of  a  corporation  for  its 
stockholders  or  other  outsiders  interested,  his  course  is  likely  to  be 
a  sort  of  combination  of  those  above,  and  yet  a  sort  of  compromise 
between  them.  He  is  not  expected  to  add  all  the  columns  and  to 
check  all  the  postings,  but  to  examine  a  sufficient  number  of  sample 
cases  to  see  that  the  proper  methods  of  bookkeeping  are  carried  out ; 
and  he  is  expected  to  study  the  general  conclusions  drawn  from  the 
accounts  to  see  whether  the  proper  methods  of  accounting  have 
been  applied. 

Practically  nothing  that  has  been  discussed  in  this  book  is  beyond 
the  field  of  the  auditor's  business.  He  is  not  only  to  examine  mat- 
ters of  philosophical  distinction  that  the  mere  bookkeeper  knows 
little  of,  but  he  must  know  innumerable  technical  details.  If  he  is 
working  on  a  corporation  report  his  knowledge  of  business  should 
be  so  wide  that  he  knows  not  only  what  methods  of  depreciation 
ought  to  be  followed,  but  also  what  actual  allowances  are  reasonable 
in  this  case.  He  must  know,  for  instance,  in  shoe  manufacturing, 
what  rate  of  depreciation  to  allow  on  the  different  sorts  of  machin- 
ery, and  on  old  stock.  In  the  wholesale  shoe  business,  he  must  know 
what  allowances  to  make  for  old  stock  on  the  shelves  and  for  bad 
bills  receivable  and  bad  accounts  receivable.  In  the  retail  shoe 
trade,  again,  he  must  know  what  valuations  he  may  use  for  the 
stock  and  for  the  book  accounts.  His  knowledge  should  include 
all  the  common  trades  —  hardly  any  two  of  which  are  alike.  He 
must  see  that  allowances  are  made  for  terminable  values,  such  as 
patents,  leases,  premium  on  bonds,  copyrights,  etc.  He  must  see 
that  provision  is  made  for  debts  due  in  the  future,  such  as  accrued 
interest,  rentals,  fees,  etc.  He  must  see  that  certain  costs  charged 
to  capital  are  not  too  long  carried  there. 

Each  case  of  this  sort,  moreover,  has  a  moral  interest.  As  stand- 
ing between  the  buyer  and  the  seller  of  a  business,  the  auditor  must 
realize  that  any  exaggeration  of  value  or  of  earning  capacity  is  un- 
fair to  the  buyer,  and  vice  versa,  and  he  must  prevent  it.  As  between 
directors  and  stockholders,  the  auditor  must  realize  that  unless 
profits  and  assets  are  correctly  reported  the  stockholder  may  be 
falsely  induced  to  sell  or  the  public  falsely  induced  to  buy;  and  his 


AUDITING  36s 

task  is  to  guarantee  honesty.  As  between  partner  and  partner,  again, 
the  same  duty  arises  whenever  a  change  in  the  terms  of  partnership 
is  contemplated.  Even  when  the  business  continues  under  the  old 
management  an  auditor  must  see  that  each  partner's  contribution 
to  the  business  is  maintained  as  agreed  by  the  articles  of  co-partner- 
ship. Auditing  has  come  of  late  years  to  rank  as  a  profession  just 
because  it  requires  not  only  a  high  quality  of  intellectual  equipment 
and  training,  but  a  high  sense  of  honor  and  of  responsibility.  Every 
part  of  accounting  from  the  merest  clerical  drudgery  to  the  most 
shrewd  financiering  should  be  so  familiar  to  the  auditor  that  he  can 
protect  not  only  the  ignorant  against  the  shrewd,  but  both  against 
themselves.  It  is  a  common  thing  for  an  auditor  to  discover  and 
disclose  in  business  affairs  conditions  of  critical  importance  of  which 
the  proprietors  and  bookkeepers  had  no  inkling. 

The  auditor's  equipment,  besides  a  thorough  knowledge  of  book- 
keeping and  accounting  principles,  should  be  a  knowledge  of  the 
various  devices  by  which  incompetent  and  dishonest  persons  mis- 
represent facts,  tact  in  dealing  with  people  so  that  he  may  learn 
what  he  wants  without  antagonism,  something  of  the  detective 
instinct  to  scent  irregularity,  and  sound  judgment  to  know  when  a 
thing  is  right  even  though  it  violates  all  traditions  and  when  it  is 
wrong  even  though  it  is  letter  perfect.  Auditing  lore  and  auditing 
methods  require  too  extensive  and  too  technical  treatment  for  in- 
clusion in  any  treatise  on  general  accounting  principles. 


I 


I 


APPENDICES 


I 


I 


I 


APPENDIX  A 

ADDITIONAL  FORMS  OF  BOOKS,  TO  SUPPLEMENT  PART  I 

Certain  interesting  forms  not  heretofore  described  are  found  in  com- 
mon use,  and  a  study  of  some  of  them  will  help  any  one  who  wishes 
to  master  the  principles  connected  with  them.  These  are  given  less  for 
their  own  sake  than  for  illustration  of  the  wide  adaptability  of  the  prin- 
ciples of  labor-saving  devices  already  explained. 

/.   Certain  Special  Forms  (for  Books  Described) 

Suppose  a  firm's  entire  business  consists  in  selling  goods  on  commis- 
sion, as  agent  for  two  or  three  principals.  If,  in  such  a  case,  the  agents 
guarantee  payment  for  their  sales,  they  make  bona  fide  purchase  of  the 
goods  which  they  sell,  and  the  entry  must  show  that  fact.  Credits  on 
the  purchase  book  will  go  to  but  two  or  three  firms;  and  the  credits  to 
commission,  naturally  entered  on  the  journal,  will  be  as  numerous  as 
the  purchases  and  will  pertain  to  the  same  items.  All  sales,  moreover, 
will  pertain  to  the  same  items.  A  simple  labor-saving  device  is  to  com- 
bine purchase  and  sales  books,  to  give  a  special  column  in  the  combined 
book  to  each  principal,  and  to  allow  in  the  same  book  a  column  for  com- 
mission.   Such  a  book  might  look  as  shown  on  page  370. 

It  is  notable  in  this  case  that  the  abbreviation  is  extreme.  One  writing 
of  items  provides  entry  for  a  purchase,  for  a  sale,  and  for  the  commis- 
sion on  that  sale :  if  all  purchases  are  made  from  two  firms,  fifty  pur- 
chases, fifty  sales,  and  fifty  commissions  can  be  covered  in  fifty  entries 
and  fifty-three  postings  —  fifty  postings  for  'sales,  two  for  purchases, 
and  one  for  commission. 

Another  interesting  device  is  one  of  those  adopted  often  to  enter 
merchandise  discounts  allowed  for  the  early  payment  of  bills.  The  sim- 
plest method,  saving  only  the  changing  of  books,  was  explained  on 
page  70.  Instead  of  writing  each  discount  on  the  page  of  the  cash 
book  opposite  the  principal  entry,  as  in  the  method  just  mentioned,  the 
discount  may  be  written  in  a  special  column  on  the  same  side  —  where 
it  distinctly  does  not  belong,  —  but  with  some  indication  that  it  is  a 
counter  entry;  and  at  the  end  of  the  month,  or  other  convenient  period, 
the  total  may  be  transferred  to  the  other  side.  That  is  to  say,  instead 
of  making  counter  entries  one  by  one,  as  by  the  method  formerly  de- 
scribed, by  this  method  the  counter  entries  are  kept  bunched  in  a  special 
column  on  the  wrong  side  and  are  at  convenient  seasons  transferred  to 
the  side  where  they  belong.  By  this  method,  too,  one  writing  of  the  entry 
and  one  posting  do  the  work  done  by  two  under  the  other  method. 

Such  a  cash  book  might  look  as  shown  on  page  371. 


370 


ACCOUNTS 


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372  ACCOUNTS 

Again,  the  same  result  is  produced  by  a  substitution  of  a  column  for 
*'net  cash"  in  place  of  the  column  for  "total"  as  above.  In  this  case 
the  contra  entry  on  each  side  of  the  cash  book  is  avoided,  for  the  amount 
of  cash  is  reported  correctly  in  the  net-cash  column.  Care  must  be  taken, 
however,  as  in  the  other  case,  that  the  discount  be  not  included  in  the 
cash  totals,  and  also  that  it  get  posted. 

The  disbursements  side  of  a  cash  book  kept  by  this  method  might 
look  as  shown  upon  page  373  (reproducing  the  items  of  the  last  ex- 
ample). 

The  main  objection  to  this  form  is  the  awkwardness  of  making  post- 
ings, for  the  amount  to  be  posted  to  customers  is  the  sum  of  the  dis- 
count and  the  net  cash,  as  $1000  in  the  entry  for  Adam  Bede  on  page 
373.  The  bookkeeper  must  post  a  sum  that  he  can  get  only  by  perform- 
ing an  addition,  usually  mental;  so  the  chance  of  error  is  large,  unless  he 
posts  two  sums,  the  discount  and  the  net  cash,  separately.  One  avoid- 
ance of  this  is  either  the  addition  of  a  column  for  totals,  or  the  substi- 
tution of  totals  for  net  cash  and  the  extension  of  the  net  cash  into  the 
column  for  sundries.  Then  the  amount  in  the  column  for  totals  and 
the  amount  in  that  for  discount  become  journal  entries,  and  the 
amount  in  the  column  for  sundries  is  a  true  cash-book  entry.  In  post- 
ing, the  bookkeeper  needs  to  look  only  at  the  total.  This  method  is 
illustrated  by  the  form  on  page  383. 

One  more  illustration  will  serve  to  complete  the  suggestions  for  spe- 
cial-column usage.  On  page  340  of  Part  II  will  be  foimd  a  discussion 
of  reasons  for  entering  merchandise  discounts  on  a  somewhat  different 
basis  from  that  commonly  adopted.  It  is  there  suggested  that  discounts 
offered  and  not  taken  are  of  as  much  importance  as  those  taken,  and 
consequently  should  be  reported  accurately,  and  that  the  corresponding 
debits  or  credits  should  be  made  to  merchandise  account. 

A  method  of  recording  such  items  is  easily  devised.  It  is  necessary 
to  note  that  when  a  discount  is  taken  the  buyer's  or  seller's  account 
must  be  credited  or  debited,  as  the  case  may  be;  but  when  the  discount 
is  not  taken  an  account  called,  perhaps,  "Neglected  Discounts"  should 
be  debited  or  one  called  "Collected  Discounts"  should  be  credited.  A 
cash  book  to  show  such  items  might  look  as  shown  on  page  374,  as- 
suming that  in  this  trade  6%  discount  is  allowed  for  payment  in  10 
days  and  5%  for  payment  in  30  days,  and  using  the  same  items  as 
on  pages  371  and  373. 


APPENDIX  A 


373 


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APPENDIX  A  375 

//.  Certain  Special  Principal  Books  for  Particular  Needs 

With  the  modem  devices  of  billing  machines,  operated  Uke  type- 
writers, having  attachments  for  addition,  and  with  the  wide  use  of  car- 
bon paper  for  making  duplicates,  it  is  possible  to  save  much  writing  in 
books  of  original  entry  by  filing  duplicates  of  bills  sent  and  making  en- 
tries in  summary  or  total  only.  Commonly  each  bill  is  made  in  carbon, 
the  total  entered  in  a  sales  journal,  as  it  is  often  called,  or  a  sales  book, 
for  posting  to  the  customer's  account,  and  the  dupUcate  of  the  bill  filed 
in  consecutive  order  by  date  or  under  the  name  of  the  purchaser. 

The  same  sort  of  thing  is  done  for  invoices  received,  though  in  this 
case  the  invoice  itself  serves  as  the  memorandum  of  the  purchase  and 
its  total  is  entered  in  the  purchase  journal,  or  purchase  book. 

Commonly  it  is  desirable  to  have  in  readily  accessible  form  a  memo- 
randum not  only  of  sums  owing,  with  the  name  of  the  creditor,  but  of 
the  date  when  due  and  the  possible  saving  by  taking  discounts.  It  is 
feasible  to  combine  such  memoranda  with  the  purchase  record  itself, 
and,  because  of  the  identification  of  the  memorandum  with  the  origi- 
nal entry,  thus  save  writing.  A  form  of  purchase  journal  for  accomplish- 
ing this  is  shown  on  the  next  page. 

When  a  business  deals  in  a  few  commodities  only  and  buys  those  from 
a  few  firms  only,  as  may  be  the  case  in  the  coal  business,  the  grain  busi- 
ness, and  various  special  lines,  it  is  possible  to  combine  purchase  journal 
and  sales  journal  with  stock  records,  and  at  the  same  time  to  eliminate 
the  purchase  ledger,  by  the  provision  of  special  columns.  If  in  the  pur- 
chase journal  a  column  is  provided  for  each  kind  of  goods  dealt  in,  and 
a  group  of  columns  for  each  firm  from  whom  purchases  are  made,  every 
purchase  entered  may  be  debited  not  only  to  Merchandise  but  also  (in 
quantity)  to  each  kind  of  stock  purchased,  and  may  be  credited  not  only 
to  Accounts  Payable  but  directly  to  the  account  of  the  particular  firm 
from  whom  the  purchase  was  made.  If  the  ruled  lines  for  entering  pur- 
chases are  sufficiently  wide  apart,  debits  to  the  accounts  of  creditors, 
for  payment  of  freight  (in  case  the  goods  are  sold  deUvered)  and  for 
remittances,  may  be  made  directly  in  the  purchase  journal  columns  — 
making  these  columns  actually  a  subordinate  ledger.  If,  then,  the  total 
debits,  in  quantity,  are  shown  for  each  kind  of  stock,  and  the  total  sales, 
in  quantity,  are  transferred  hence  from  the  sales  journal  (kept  so  as  to 
provide  the  figures),  the  differences  will  be  the  balances  of  stock  on  hand; 


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and  of  course  these  may  be  taken  monthly,  weekly,  or  even  daUy,  as 
convenience  dictates.  A  purchase  journal  for  use  under  such  conditions 
is  shown  on  page  377. 

It  is  often  desirable  to  provide  memoranda  for  the  dates  on  which 
customers  are  expected  to  pay  their  bills,  so  that  the  credit  value  of  the 
accounts  may  be  watched  with  care  and  reminders  may  be  sent  in  case 
of  delays.   Since  commonly  alternatives  of  payment  are  offered,  such 
as  one  or  more  rates  of  discount  in  case  of  early  payment,  it  is  not  al- 
ways possible  to  tell  when  payments  will  be  made,  and  memorandum 
should  be  made  of  the  date  of  actual  payment.  If  the  business  is  not  very 
large  such  memoranda  may  with  advantage  be  combined  with  a  sales 
journal,  or  sales  book,  by  the  provision  of  columns  for  future  dates  of 
payment.  Often,  moreover,  manufacturers  and  others  are  glad  to  keep 
their  goods  moving  and  to  provide  for  the  far-distant  payment  of  bills 
by  what  is  commonly  called  "dating  ahead";  so  that  goods  sold  on  the 
first  of  July  may  be  billed  as  of  October  i  and  discounts  offered  even 
then  for  early  payment  after  October  i.  Usually  in  such  cases  the  cus- 
tomer is  offered  not  only  discount  for  payment  soon  after  October  i  but 
a  further  allowance  for  interest  in  case  of  payment  earlier  than  that. 
Then  two  memoranda  of  reductions  should  be  provided  for;  special  col- 
umns under  the  head  of  the  various  months  will  serve  this  purpose.  A 
form  to  fulfill  these  purposes  and  at  the  same  time  to  provide  the  state- 
ment of  quantities  of  sales,  as  suggested  in  the  last  paragraph,  is  shown 
below.  The  date  when  the  bill  is  due  is  always  entered  on  the  assump- 
tion that  discounts  will  not  be  taken,  for  only  then  has  the  firm  the  right 
to  urge  payment.  If  the  bill  is  paid  earUer,  the  amount  is  canceled  where 
originally  written  and  reentered  under  the  month  when  paid,  with  the 
interest  and  discount  and  net  cash.  The  amount  in  the  column  headed 
"total"  is  the  original  debit,  and  the  other  amounts  are  not  entered  un- 
til payment  is  finally  made.  If  the  bill  is  not  paid  when  due,  the  amount 
is  carried  over  into  the  columns  headed  "overdue."  If  a  long  period  of 
credit  is  allowed,  maturities  for  sales  made  in  any  month  may  fall  in 
any  one  of  several  months,  and  then  many  columns  will  be  required; 
but  in  any  case,  since  all  items  due  in  any  month  will  fall  in  the  columns 
for  that  month,  maturing  items  may  be  easily  watched,  and,  since  at  the 
end  of  any  month  all  items  falling  within  it  will  have  been  either  paid  or 
transferred,  attention  need  never  be  given  to  any  other  columns  than 
those  for  the  present  month  and  for  overdue  items.  The  totals  of  cash, 


I 


APPENDIX  A 


379 


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of  discount,  and  of  interest  should  be  taken  each  month  for  compari- 
son with  the  cash-book  figures.  In  large  businesses,  of  course,  memo- 
randa of  credit  transactions  would  require  more  complete  classifica- 
tion, for  more  ready  reference,  and  there  consolidation  in  such  a  sales 
journal  would  be  inadvisable.  The  form  above  described  is  shown  on 
page  379. 

An  interesting  set  of  books  is  often  required  in  a  shipping  and  com- 
mission business.  Such  a  business  is  likely  to  have  four  controlling  ac- 
counts for  four  sorts  of  relations  with  outsiders.  Since  it  receives  goods 
to  be  sold  on  commission,  it  must  show  its  relations  with  consignors; 
but  it  has  no  financial  responsibility  to  consignors  until  consigned  goods 
are  sold,  and  hence  consignors  do  not  immediately  receive  credit  for 
goods  consigned  though  the  goods  must  be  recorded.  Since  it  ships 
goods  on  consignment  to  others,  it  must  debit  the  cost  of  such  shipments, 
but  it  cannot  debit  the  consignees,  for  the  latter  are  not  responsible  for 
payment  until  or  unless  the  goods  are  sold.  Since  it  both  buys  and  sells, 
it  has  the  usual  controlling  accounts  for  creditors  and  customers.  A  con- 
venient way  of  arranging  and  handling  the  books  may  be  summarized 
briefly. 

Each  lot  of  goods  received  on  consignment  is  given  a  lot  nmnber  and 
is  entered  in  a  receiving  or  consignments  book,  which,  with  ample  space 
for  each  lot  number,  may  serve  as  a  subordinate  ledger  controlled  by  a 
Consignments  account.  If  freight  bills  or  other  memoranda  of  incom- 
ing goods  are  numbered  and  filed,  the  receiving  book  should  give  a 
reference  number  to  such  original  documents,  with  date  of  receipt,  name 
of  consignor,  and  detailed  list  of  articles  received.  So  far  this  consign- 
ments book  is  a  memorandum  book.  To  it  may  be  posted  later,  making 
it  a  ledger,  any  debits  and  credits  relating  to  this  specific  consignment  — 
such  as  freight  charges  paid,  commission,  remittances  on  "  account  sales,'' 
and  receipts  from  goods  sold.  All  these  except  the  last  would  normally 
reach  the  receiving  book  through  the  cash  book.  The  sales  should  be 
entered  in  detail,  for  the  consignee  must  account  in  detail  for  everything 
consigned  to  him;  and  hence  the  sales  book  must  show  the  lot  number  of 
each  article  sold.  If  the  firm  sells  its  own  merchandise,  it  may  have  two 
sales  books,  one  for  cash  sales  and  one  for  charge  sales,  each  with  a  col- 
umn for  consigned  goods  and  one  for  merchandise,  or  it  may  have  four 
columns  in  a  single  book  (or  four  columns  on  sales  sheets  filed  and  used 
as  posting  media),  one  each  for  cash,  for  accounts  receivable,  for  con- 


APPENDIX  A  381 

signments,  and  for  merchandise.  In  some  cases  it  is  preferable  to  keep 
the  consignments  book  as  a  pure  book  of  original  entry,  using  it  only  for 
entering  the  articles  received  and  freight  charges  on  them.  Then  a  special 
consignments  ledger,  controlled  by  Consignments  in  the  general  ledger, 
would  be  kept  for  all  postings,  and  postings  would  be  made  to  it  not  only 
from  the  cash  book  and  from  the  sales  book,  but  from  the  consignments 
book  (for  freight  paid  —  the  credit  being  to  Freight,  which  in  turn  is 
debited  from  the  cash  book).  It  might  well  be  arranged  by  consignor's 
names  rather  than  by  lot  numbers. 

The  accounting  for  shipments  is  somewhat  similar,  but,  though  it 
avoids  the  irregularity  of  quasi  credits  for  unknown  amounts,  it  has  the 
new  feature  of  recording  profits  and  losses  piecemeal;  for  proper  ac- 
counting will  learn  profit  or  loss  on  every  shipment  —  as  a  guide  to 
future  operations.  A  shipments  book,  for  debiting  Shipments  control- 
ling account  and  the  individual  shipment  accounts  for  goods  shipped, 
with  the  charges  —  such  as  cartage  and  freight,  —  is  the  foundation  of 
the  accounting.  The  total  of  this  book  for  any  period  is  debited  to  Ship- 
ments and  credited  to  Merchandise  and  Freight  and  Cartage,  and  the 
amount  of  debit  to  each  shipment  is  posted  to  a  shipments  ledger  having 
an  account  for  each  shipment  (designated  by  number  or  by  consignee's 
name).  Then  on  the  receipt  of  remittances  on  "account  sales"  from 
each  consignee,  credit  is  made  to  Shipments  and  to  the  individual  ship- 
ments accounts  (or,  if  desirable,  credits  may  be  made  on  the  receipt  of 
notice  of  sales,  and  Accounts  Receivable  may  be  debited).  If  a  ship- 
ment results  in  a  gain  or  in  a  loss,  the  cash  received  will  not  close  the 
individual  shipment  account,  of  course;  for  more  or  less  than  the  amount 
debited  will  have  been  credited.  This  balance  may  be  left  on  the  books 
for  future  closing,  or  it  may  be  taken  over  at  once  into  the  nominal  ac- 
counts. A  manager  will  surely  wish  to  know  the  facts  at  once,  and  when 
they  have  been  once  looked  up  they  should  be  recorded  —  rather  than 
require  a  second  looking- up  for  closing  purposes.  This  closing  entry 
is  most  conveniently  made  in  direct  connection  with  the  entry  for  the 
remittance  (or  for  the  transfer  to  Accounts  Receivable).  It  is  shown 
below  on  the  cash  book.  The  controlling  account  must  also,  of  course, 
take  the  corresponding  debits  and  credits.  If  desired,  the  shipments 
book  may  itself  be  kept  as  a  ledger,  though  to  it,  of  course,  must  be 
carried  full  details  of  the  goods  shipped.  The  original  entry  would  be 
a  summary  in  the  sales  book. 


382 


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APPENDIX  A 


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384  ACCOUNTS 

The  cash  book  shows  relations  with  all  four  controlling  accounts, 
all  of  which  have  contra  items.  The  form  shown,  it  will  be  noted,  is  not 
a  pure  cash  book,  for  the  contra  items  (discounts,  commission,  losses, 
gains)  are  not  extended  into  any  pure  cash  columns,  but  are  treated 
as  journal  items.  Only  net  cash  goes  into  cash  columns.  If  any  column 
contains  gross  items,  the  net  is  at  once  extended  into  the  sundries 
cash  column  and  the  total  of  the  gross  column  as  well  as  that  of  the 
contra  column  is  treated  as  a  journal  item;  but  items  entered  only  as 
net  are  extended  into  the  final  cash  column  only  as  totals.  Double  rul- 
ings under  totals  indicate  journal  items,  though  sub-totals  in  the  same 
columns  (as  with  receipts  from  shipments)  may  have  been  entered  as 
net  cash  items.  This  double  ruling  satisfies  the  eye  that  the  failure  to 
transfer  to  the  column  for  sundries  the  totals  of  certain  special  columns 
was  not  due  to  oversight.  The  transactions  of  the  first  three  columns 
on  the  receipts  side  of  this  cash  book  may  be  expressed  in  terms  of  a 
journal  entry  as  follows: 

Cash  413.70 

Loss  5.10 

To  Gain  6.25 

Shipments  412.55 

Loss  and  Gain  are  here  posted  separately  and  to  separate  accounts,  for, 
as  each  venture  is  independent  of  every  other  and  every  loss  is  a  failure 
and  not  a  normal  cost,  the  significance  of  the  losses  would  be  missed 
if  they  were  set  off  against  the  gains.  In  closing  the  books,  each  of 
these  accounts  would  be  closed  to  Profit  and  Loss  —  the  ultimate  nom- 
inal account.  The  forms  for  the  cash  book  are  found  on  pages  382 
and  383. 

The  most  interesting  special  forms  of  books  are  found  perhaps  in  bank 
bookkeeping.  Most  banks  have  devices  more  or  less  peculiar  to  them- 
selves, but  the  principles  are  usually  the  same.  Everything  handled  by 
a  bank  in  the  ordinary  course  of  its  business  is  either  money  itself  or  a 
written  claim  to  money  which  bears  upon  its  face  or  on  its  back  writing 
that  sufficiently  testifies  to  its  source,  destination,  character,  and  pre- 
sumable value.  Hence  usually  in  bank  bookkeeping  very  few  detailed 
entries  are  necessary.  Banks  accordingly  can  combine  what  in  other 
businesses  are  purchase  book,  sales  book,  purchase  ledger,  and  sales 
ledger,  into  one  book  —  the  so-called  deposit  ledger,  or  individual  ledger. 
No  advantage  could  be  derived  from  entering  in  a  journal,  or  purchase 


APPENDIX  A  385 

book,  deposits  by  patrons  of  a  bank ;  for  those  deposits  are  either  actual 
money  or  else  claims  for  money  which  if  ultimately  proved  worthless 
can  be  traced,  by  means  of  the  endorsements,  directly  back  to  the  de- 
positor. The  only  record  necessary  is  a  debit  to  Cash  and  a  credit  to  the 
depositor.  If,  then,  the  deposits  for  each  day  are  entered  in  a  special 
column,  opposite  the  name  of  each  depositor,  the  total  of  the  column 
for  the  day  is  the  debit  to  Cash,  and  the  line  devoted  to  each  depositor, 
if  so  desired,  can  be  used  as  a  part  of  that  depositor's  ledger  account. 
Of  course  the  same  principle  may  be  used  for  withdrawals  of  money 
by  checks  paid.  Such  is  the  common  practice.  The  result  is  the 
deposit  ledger,  of  which  the  form  on  page  386  represents  a  part  of  a 
page. 

Sometimes  a  special  column  is  given  for  deposits  in  total,  but  that 
is  usually  unnecessary.  Commonly  cash  deposits  are  made  but  once  a 
day.  When,  however,  a  depositor  has  many  transactions  with  his  bank 
by  the  discounting  and  the  collection  of  notes  and  drafts,  such  a  column 
may  be  desirable,  for  in  such  a  case  one  figure  is  to  be  taken  from 
a  deposit  slip,  and  possibly  others  from  the  discount  and  the  collec- 
tion register.  In  the  form  shown,  the  amount  of  $1,416.20,  credited  to 
James  Robinson,  on  April  24,  is  put  in  italics  (or  it  might  be  put  in 
red  ink)  to  signify  that  it  was  not  a  deposit  of  cash,  but  was  allowed  James 
Robinson  for  a  note  discounted,  of  which  the  proceeds  were  left  on 
deposit. 

In  consequence  of  this  form  for  the  deposit  ledger,  the  balance  of 
each  customer's  account  is  figured  and  entered  daily.  The  total  of  all 
balances  should  of  course  agree  with  the  balance  of  the  account  repre- 
senting depositors,  or  "  Deposits,"  in  the  general  ledger,  —  for  De- 
posits in  banking  corresponds  with  Accounts  Payable  in  commercial 
business. 

In  the  case  of  so-called  "inactive"  accounts,  such  as  accounts  of  per- 
sons not  engaged  in  business,  banks  do  not  need  to  allow  a  set  of  col- 
umns for  each  day's  record,  and  hence  for  the  ordinary  deposit  ledger 
they  substitute  a  similar  form  in  which  a  page  may  be  used  for  a  month 
or  longer.  In  these  the  columns  are  not  designated  for  the  same  day  for 
all  depositors  alike,  but  the  date  of  each  transaction  is  entered  for  each 
depositor  independently  of  the  dates  for  other  depositors,  as  need  may 
be. 

It  is  thus  clear  that  the  deposit  ledger  in  banking  is,  unlike  other 


386 


ACCOUNTS 


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APPENDIX  A  387 

ledgers  so  far  described,  a  book  of  original  entry.  No  postings  are  made 
to  it :  on  the  contrary,  postings  may  be  made  from  it.  It  is  a  combined 
journal  and  subordinate  ledger.  From  it  figures  must  be  taken  to  show 
necessary  postings  to  Deposits  and  to  Cash.  Obviously,  the  total  of  the 
column  headed  ''Checks  total"  must  be  debited  to  Deposits,  for  it 
represents  what  has  been  paid  to  depositors.  Similarly  it  is  a  credit  to 
Cash  and  hence  may  be  transferred  to  the  cash  book  —  or  journal,  or 
day-book,  as  it  is  sometimes  called  in  banking,  since  no  other  journal  or 
day-book  is  necessary  —  at  the  close  of  the  day.  Obviously,  too,  the 
total  of  the  column  marked  "deposits"  should  be  credited  to  Deposits 
in  the  general  ledger;  but  this  total  is  not  necessarily  the  correct  debit 
to  cash,  for  some  of  these  credits  to  patrons  are  due  not  to  deposits  of 
cash,  but  to  the  discounting  of  notes  and  drafts  of  which  the  proceeds 
are  left  on  deposit.  If  correct  charge  to  cash  is  to  be  made,  therefore, 
the  deposits  by  discounted  notes  should  not  be  included  in  that  part 
of  the  total  which  is  carried  to  the  cash  book.  The  deposits  column  of 
the  deposit  ledger  may  well  have  two  footings,  therefore,  —  the  full 
total  showing  the  desired  credit  to  Deposits  in  the  general  ledger,  and 
a  total  omitting  deposits  by  discount  but  showing  the  debit  to  Cash. 
Thus,  except  for  the  unposted  debit  to  Bills  Receivable  —  the  other 
half  of  our  entry  crediting  depositors  for  discounted  notes  and  drafts,  — 
our  entries  are  so  far  complete,  with  a  debit  for  every  credit.  To  post 
this  figure  of  proceeds  of  discounted  notes  as  a  debit  to  Bills  Receivable 
—  or  Bills  Discounted,  as  the  account  is  usually  called  in  banking  — 
would  at  best  accomplish  but  in  part  the  necessary  debit  posting  to  Bills 
Discounted,  for  the  debit  to  Bills  Discounted  should  be  not  only  the  pro- 
ceeds of  notes  but  the  full  face  value.  This  debit  can  be  conveniently 
made  from  the  discount  register. 

The  discount  register  is  a  book  containing  practically  every  detail 
that  any  one  could  wish  to  know  about  each  note.  The  information  is 
kept  in  columns  containing,  for  each  note,  the  name  of  the  maker,  the 
names  of  the  endorsers,  the  place  at  which  it  is  payable,  the  date,  the 
length  of  time  specified  before  payment,  the  date  of  maturity,  the  face 
value,  the  amount  of  discount,  the  amount  of  collection  fee  if  any,  the 
amount  of  net  proceeds,  and  the  name  of  the  person  for  whom  the  bank 
discounted  it.  From  the  last  two  columns  are  transferred  to  the  deposit 
ledger  the  proper  credits  to  individual  depositors,  as  already  shown. 
The  total  of  the  other  three  columns  of  dollars  and  cents  is  clearly  to  be 


388  ACCOUNTS 

posted.  The  total  of  the  column  for  face  values  is  simply  the  debit  to 
Bills  Discounted  in  the  general  ledger;  the  total  of  the  column  for  dis- 
counts is  the  credit  to  Discount  in  the  general  ledger;  and  the  total 
of  the  column  for  collections  is  the  credit  to  Collection  in  the  general 
ledger.    Postings  may  be  made  accordingly. 

One  complication  occurs  in  this  book,  however,  similar  to  that  oc- 
curring in  the  deposit  ledger.  Not  all  discounts  are  for  deposit :  some 
discounts  are  for  cash,  made  to  persons  having  no  deposit  account  at  the 
bank  making  the  discount.  So  far  as  such  discounts  are  made,  the  total 
of  the  column  for  proceeds  of  notes  discounted  is  not  necessarily  a  credit 
to  depositors,  but  is  in  part  a  credit  to  Cash.  Hence  the  two  kinds  of  dis- 
counts must  be  distinguished  (by  red  ink  or  back-slant  figures,  for  ex- 
ample), and  each  must  be  taken  in  distinct  total  and  posted  to  the 
proper  account. 

It  may  now  pay  to  summarize  these  two  books  up  to  this  point.  The 
discount  register,  so  far  as  it  has  been  here  discussed,  represents  this 
journal  entry: 

Bills  Discounted 

To  Discount 

To  Collection 

To  Depositors 

To  Cash 

The  deposit  ledger  represents  these  journal  entries: 

Depositors 

To  Cash 

and 

Cash 

Bills  Discounted 

To  Depositors 

The  debit  to  Bills  Discounted  by  a  credit  to  depositors  occurs  in  both 
books.  In  posting.  Bills  Discounted  may  be  posted  from  the  discount 
register,  because  there  the  figure  is  complete,  whereas  in  the  deposit 
ledger  it  includes  only  proceeds  and  does  not  include  cash  discounts  and 
if  posted  thence  would  need  to  be  supplemented  by  another  posting  for 
the  omitted  balance.  Discount  and  Collection  may  also  be  posted  from 
the  discount  register.  The  credit  to  Deposits  would  naturally  be  posted 
from  the  deposit  ledger  rather  than  from  the  discount  register,  for  in 


APPENDIX  A 


389 


I 


the  deposit  ledger  the  figure  is  complete,  representing  both  kinds  of 
deposits,  whereas  in  the  discount  register  it  is  but  partial  and  would 
need  to  be  supplemented  by  another  posting  for  cash  deposits.  The  only 
remaining  postings  to  be  made  for  these  transactions  are  the  credits  to 
Gash  for  cash  discounts,  debits  to  Deposits  and  credits  to  Cash  for  cash 
withdrawals  on  checks  paid  by  the  bank,  and  the  debits  to  Cash  for 
the  cash  deposits.  All  these  must  in  any  case  go  to  the  cash  book,  and 
to  post  them  thence  is  the  natural  process.  A  repetition  of  the  journal 
entries  given  above  with  an  indication  of  the  disposition  of  the  items  may 
help  the  reader  to  see  that  everything  is  now  provided  for. 


f  Bills  Discounted 
To  Discount 
Collection 

'  Depositors  (in  deposit  ledger)  | 
Deposits  (in  general  ledger)     J 
Cash  (proceeds  only) 


Posted 

Directly 

Yes 

Yes 

Yes 

No 

No 


Transferred  Whence  already 
to  Posted 


Deposit  ledg. 
Cash  book 


'  Deposits  (in  the  general  ledger)  No  Cash  book  

li,        To  Cash  No  Cash  book  

Cash  No  Cash  book  

Bills  Discounted  No  Disc.  reg. 

To  Deposits  (in  general  ledger)  Yes  

It  thus  appears  that  each  part  of  each  item  is  either  posted  directly 
or  transferred  to  another  book  whence  it  may  be  posted  directly.  The 
only  complication  that  exists  in  posting,  under  the  system  thus  far  de- 
scribed, is  due  to  the  fact  that  both  the  discount  register  and  the  deposit 
ledger  contain  totals  which  must  be  split  in  two,  the  disposition  of  the 
two  parts  differing:  in  transferring  cash  discounts  from  the  discount 
register  to  the  cash  book,  care  must  be  taken  that  the  discounts  for  de- 
posit be  not  included,  else  the  credit  to  Cash  will  be  excessive  by  the 
amount  of  such  discounts  for  deposit ;  and  in  transferring  cash  deposits 
from  the  deposit  ledger  to  the  cash  book,  care  must  be  taken  that  de- 
posits by  discount  be  not  included,  else  the  debit  to  Cash  will  be  excessive 
by  the  amount  of  such  discounts  for  deposit. 

It  is  now  to  be  noted  that  the  amount  likely  to  slip  in  by  mistake  in 


390 


ACCOUNTS 


each  case,  as  just  explained,  is  the  same  amount :  it  is  the  discounts  for 
deposit  in  the  discount  register,  and  it  is  deposits  by  discount  in  the  deposit 
ledger,  —  the  same  sum,  in  one  book  considered  primarily  as  a  discount 
and  in  the  other  book  primarily  as  a  deposit.  It  is  to  be  noted,  too,  that 
incorrectly  to  include  this  sum  in  the  total  from  the  discount  register  is 
to  credit  cash  excessively,  and  to  include  it  from  the  deposit  ledger  is  to 
debit  cash  excessively.  Hence  if  both  errors  are  committed,  no  balance 
of  error  remains.  Most  banks,  therefore,  on  the  principle  already  dis- 
cussed on  page  70,  do  not  bother  to  separate  cash-discounts  from  dis- 
counts-for-deposit  in  the  totals  of  the  discount  register,  nor  cash-deposits 
from  deposits-from-discount  in  the  deposit  ledger.  The  posting  of  such 
items  may  be  made,  then,  not  merely  by  direct  posting  to  the  ledger,  but 
by  transferring  the  total  discounts  from  the  discount  register  to  the  cash 
book  as  a  debit  to  Bills  Discounted  and  a  credit  to  Cash,  and  trans- 
ferring the  total  deposits  from  the  deposit  ledger  to  the  cash  book  as  a 
debit  to  Cash  and  a  credit  to  Deposits.  This  is  treating  the  transactions 
exactly  as  if  every  one  who  discounted  a  note  for  deposit  withdrew  the 
actual  cash  and  then  deposited  it.  Postings  to  the  general  ledger  are 
made  from  the  cash  book  in  the  usual  course.  This  system,  though  it 
complicates  the  bookkeeping  in  theory,  much  simplifies  the  work  of  the 
bookkeepers  in  practice. 

It  is  possible  to  carry  this  same  sort  of  short-cut  one  step  farther.  We 
have  just  entered  in  the  cash  book  two  fictions  to  ofi'set  each  other,  and, 
as  a  consequence,  we  get  rid  of  the  necessity  of  posting  from  the  deposit 
ledger  at  all;  for  now  our  total  of  deposits  is  in  the  cash  book  and  can  be 
posted  thence  as  well  as  from  the  deposit  ledger.  So  posting  is  simplified. 
With  three  exceptions,  all  figures  to  be  posted  are  now  conveniently 
handy  in  the  cash  book:  these  three  are  Bills  Discounted,  Dr.;  Collec- 
tion, Cr. ;  and  Discount,  Cr.  We  have  in  the  cash  book,  however,  as  a 
cash  disbursement,  the  proceeds  of  all  bills  discounted,  though  this  fig- 
ure is  not  to  be  posted  thence.  Now  it  happens  that  the  difference  be- 
tween the  face  of  bills  discounted  (or  the  proper  debit  to  Bills  Dis- 
counted) and  the  proceeds  now  appearing  on  the  cash  book  is  just  the 
amount  of  the  credits  to  Collection  and  Discount.  If,  then,  we  should 
carry  to  the  cash  book  the  amount  of  the  face  of  bills  discounted,  instead 
of  the  amount  of  proceeds,  and  post  this  figure  as  a  debit  to  Bills  Dis- 
counted, and  then  should  also  carry  to  the  cash  book  the  totals  of  dis- 
count and  collection,  the  cash  would  be  overstated  as  much  on  one  side 


APPENDIX   A  391 

as  on  the  other,  and  all  would  be  well.  Then  all  posting  could  be  done 
from  the  cash  book,  and  confusion  in  posting,  partly  from  one  book  and 
partly  from  others,  would  be  avoided.  The  process  is  simply  another 
illustration  of  representing  on  opposite  sides  of  the  cash  book  two  fictions 
that  offset  each  other  and  might  well  be  facts  —  as  if  certain  money 
had  been  passed  out  at  one  window  and  taken  in  at  another.^  This  is 
the  method  usually  adopted. 

In  consequence  of  all  this,  the  bookkeeping  is  in  practice  very  simple. 
All  totals  in  the  deposit  ledger,  and  all  totals  except  proceeds  in  the  dis- 
count register,  are  transferred  directly  to  the  cash  book.  It  is  now  inter- 
esting to  see  the  actual  appearance  of  the  books  under  this  method  of 
treatment.  Let  us  assume  the  footings  of  a  discount  register  to  be  as 
follows : 

Face  of  Notes  Discount  Collection  Proceeds 

$83,297.10  $517-62  $15.24  $82,764.24 

^  As  a  matter  of  fact,  the  contrary  is  usually  true  when  discounts  are  made  for 
cash.  In  banks  large  enough  to  employ  considerable  division  of  labor,  the  payment 
of  cash  for  discounts  is  commonly  through  the  medium  of  cashier's  checks,  and  these, 
as  it  chances,  are  treated  on  the  deposit  ledger  similarly  to  general  deposits.  The 
account  called  "Cashier's  Checks,"  and  two  others  of  a  like  nature,  "Certificates  of 
Deposit"  and  "Certified  Checks,"  are  worth  comment. 

A  certificate  of  deposit  is  issued  when  a  depositor  wishes  not  a  running  account  sub- 
ject to  check,  but  a  temporary  account  subject  to  withdrawal  as  a  whole  on  presenta- 
tion of  the  certificate.  In  that  case  no  account  need  be  kept  on  the  books  with  the 
depositor  as  an  individual,  and  all  outstanding  certificates  may  be  lumped  in  one 
account.  A  credit  to  Certificates  of  Deposit  when  the  deposit  is  made  and  the  certifi- 
cate is  issued,  and  a  debit  when  it  is  paid,  serve  the  full  purpose. 

Certified  checks  are  those  upon  which  the  bank  has  guaranteed  payment,  and  they 
are  therefore  really  accepted  drafts.  As  soon  as  a  check  is  certified,  therefore,  the 
account  of  the  drawer  must  be  debited  and  Certified  Checks  must  be  credited ;  that  is, 
the  credit  or  liability  for  the  deposit  is  transferred  from  the  account  of  the  original 
depositor  to  Certified  Checks.   When  the  checks  are  paid,  the  account  is  debited. 

Similarly,  when  a  note  is  discounted  and  cash  is  desired,  a  cashier's  check  is  is- 
sued ordering  the  paying  teller  to  deliver  the  money.  Cashier's  Checks  is  credited, 
for  the  proceeds  of  the  note  have  been  deposited  and  until  the  check  is  paid,  whether 
the  time  be  ten  seconds  or  ten  weeks,  the  books  should  show  a  liability  for  the  deposit. 
When  the  check  is  paid  the  account  is  debited,  of  course. 

One's  natural  impulse  is  to  think  of  these  three  accounts  as  having  debit  balances, 
for  their  names  suggest  outgo,  but  since  in  each  case  a  liability  for  some  sort  of  deposit 
antedates  the  issue  of  the  certificate,  the  books  should  always  show  for  them  a  credit 
balance  if  any  are  outstanding. 


392  ACCOUNTS 

and  the  footings  of  a  deposit  ledger  as  follows: 

Checks  total  Deposits 

$80,149.36  $76,327.19 

So  far  as  these  items  are  concerned,  the  cash  book  would  look  as  follows: 

Receipts  Disbursements 

Discount  517.62  Bills  Discounted  83,297.10 

Collection  15-24  Deposits  80,149.36 

Deposits  76,327.19 

All  these  items  would  be  posted  to  the  general  ledger  similarly  to  any 
other  items. 

The  figures  given  above  appear  at  first  glance  to  show  a  rapid  deple- 
tion of  cash,  but  the  full  cash  book  would  of  course  show  large  receipts 
of  cash  from  the  payment  of  matured  notes  previously  discounted, — 
for  the  payment  of  which  many  of  the  checks  here  recorded  as  paid  were 
probably  drawn.  The  payment  of  these  notes  cannot  be  taken  from  the 
discount  register,  but  must  be  entered  independently,  for  in  that  book 
the  notes  are  arranged  in  order  of  purchase  and  the  payments  of  any 
one  day  could  not  be  found  in  any  one  place.  The  other  items  of  a  bank 
cash  book  are  likely  to  be  self-explanatory. 

Banks  use,  of  course,  many  auxiliary  books  for  convenience,  such  as 
the  so-called  ticklers  (described  in  Appendix  A,  III)  for  rearranging 
the  record  of  notes  and  drafts  according  to  maturity  —  so  that  none  shall 
be  overlooked  at  the  time  provided  for  presentation  to  secure  the  liabil- 
ity of  endorsers,  —  and  the  collection  register,  for  recording  notes  and 
drafts  entrusted  to  the  bank  for  collection.  The  collection  register 
differs  from  the  discount  register  chiefly  in  the  fact  that  the  bank  holds 
no  title  in  paper  for  collection  and  hence  makes  no  entry  upon  its  prin- 
cipal books  until  collection  is  made ;  and  then  it  merely  credits  the  patron 
for  whom  the  collection  was  made,  as  if  the  collection  were  a  simple 
deposit. 

Many  banks  keep  their  general  ledger  in  the  same  form  as  that  of  the 
deposit  ledger,  and  this  method  provides  easy  means  for  a  daily  trial 
balance.  Postings  may  be  made  to  such  a  ledger  as  easily  as  to  one  of 
the  ordinary  form,  and  as  the  balance  is  figured  daily  very  little  work 
is  required  for  the  construction  of  a  trial  balance.  Indeed  the  ledger 
itself  may  be  said  to  be  a  trial  balance.  This  form  is  desirable,  however, 


APPENDIX    A  393 

only  when  changes  are  so  frequent,  in  connection  with  most  accounts, 
that  the  labor  of  bringing  over  new  balances  is  worth  while. 

Many  banks  do  not  use  the  form  of  deposit  ledger  here  shown,  but 
one  more  like  the  ordinary  ledger  —  though  with  an  extra  column  for 
balances. 

This  discussion  is  intended  not  to  treat  bank  bookkeeping  exhaust- 
ively, but  merely  to  show  certain  interesting  types  of  device  that  may 
be  applied  in  other  connections. 

A  device  somewhat  similar  to  the  deposit  ledger,  commonly  called  the 
''tabular  ledger,"  saves  much  labor  of  writing  in  businesses  where  cus- 
tomers are  many  but  transactions  are  few  and  always  of  predetermined 
sorts.  An  electric  service  company,  for  instance,  has  a  few  fundamental 
charges  to  patrons,  such  as  lighting  consumption,  power  consumption, 
appliances,  lamps,  installations,  etc.,  and  it  may  allow  discounts.  Groups 
of  columns,  one  for  each  sort  of  item  just  mentioned,  make  possible  the 
entry  of  charges  without  explanation.  When  the  business  is  one  in  which 
charges  are  constant,  bills  may  be  made  out  merely  from  the  distribu- 
tion of  items  among  columns  without  reference  to  original  documents. 

If  the  ledger  is  in  the  horizontal  form  of  the  deposit  ledger  just  de- 
scribed for  banks,  this  tabular  ledger  may  be  also  a  book  of  original  en- 
try. With  names  down  the  side  and  a  column  for  each  kind  of  charge 
item  for  each  of  six  months,  for  example,  one  set  of  names  would  last 
six  months,  and  for  each  of  those  months  the  total  of  each  column  would 
show  for  the  month  the  earning  of  the  company  on  the  score  indicated. 
Then  each  month  the  total  of  the  earnings  columns  would  be  debited  to 
Accounts  Receivable,  and  credited  to  the  earnings  accounts,  in  the  gen- 
eral ledger.  This  tabular  ledger  would  then  be  kept,  without  posting, 
in  the  mere  process  of  making  original  entries.  A  brief  illustration  of 
the  form  will  be  found  on  page  394. 

A  word  should  be  said  about  department-store  accounts,  for  they  il- 
lustrate the  need  not  only  of  tying  the  books  together  but  of  establishing 
checks  on  the  accuracy  of  the  records.  In  most  large  department  stores 
the  possibilities  of  theft  and  defalcation  are  many  unless  internal  checks 
are  provided.  A  discussion  of  all  the  details  of  department-store  accounts 
would  require  many  pages,  but  a  summary  view  is  worth  while  here. 
All  sales  are  recorded  on  sales  slips,  and  distinction  is  made  between 
cash  sales,  charge  sales,  and  "  c.o.d."  sales.  Each  clerk  keeps  a  memoran- 
dum of  the  amount  of  each  sale  and  makes  and  reports  a  summary  for 


394 


ACCOUNTS 


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APPENDIX   A  395 

the  day.  The  sales  slips  are  compared  with  the  goods  delivered,  and  at 
the  end  of  the  day  with  the  total  reported  sales  of  the  clerk.  The  amount 
of  cash  sales  shows  the  amount  for  which  the  cashier  is  responsible,  the 
amount  of  charge  sales  shows  the  amount  for  which  the  bookkeepers  are 
responsible  to  make  charges,  and  the  amount  of  ''c.o.d."  sales  measures 
the  responsibiUty  for  early  cash  collections.  If  no  goods  go  out  without 
a  ticket,  and  inspection  is  intended  to  be  rigid,  and  if  the  prices  on  tickets 
are  right,  the  business  is  protected  against  loss  up  to  the  charges  to 
Accounts  Receivable.  (Incidentally,  the  sales  sUps  are  entered  also  to 
show  the  sales  of  each  clerk  as  a  measure  of  his  value  to  the  business,  to 
show  the  sales  of  each  department  as  a  measure  of  its  value  and  its  ac- 
tivity and  its  comparative  expense,  and  to  show  the  sales  for  each  day 
and  week  and  month  as  a  measure  of  growth  in  comparison  with  other 
years.)  By  a  system  of  internal  audit,  providing  abstracts  from  all 
charge  sales  slips,  before  the  charge  tickets  reach  the  bookkeeper's  de- 
partment, and  summaries  of  accounts  with  customers,  and  requiring 
summaries  also  of  cash  and  other  credits  before  such  credits  are  reported 
to  the  bookkeepers,  the  bookkeeping  department  is  held  to  account  for 
all  charges  and  the  cashier's  department  to  account  for  all  cancellations 
of  charges.  Any  failure  of  the  books  and  the  cash  to  tally  with  the  audit 
department's  detailed  figures  discloses  irregularity,  and  the  discrepancy 
can  be  traced  because  a  memorandum  has  been  made  and  preserved  for 
every  item.  In  a  well-organized  establishment  only  large  collusion  and 
theft  of  goods  where  adequate  inspection  is  impossible  are  left  as  open 
doors. 

As  already  indicated,  the  forms  and  discussion  of  this  section  are  in- 
tended to  show  not  complete  bookkeeping  systems  for  specific  businesses, 
or  a  complete  system  for  any  business,  but  typical  applications  of  the 
devices  described  in  Chapter  VI.  A  thorough  understanding  of  these 
few  applications  should  enable  any  one  to  comprehend  virtually  any 
type  of  bookkeeping  form  —  if  he  knows  enough  of  the  technique  of  the 
business  to  know  the  meaning  of  the  facts  disclosed,  —  and  to  devise  a 
form  or  system  for  any  need  which  his  knowledge  of  the  technique  of  a 
business  may  indicate  to  him.  Only  experience,  however,  \v411  teach  one 
how  to  construct  the  best  form.  That  best  form  must  combine  many  ele- 
ments more  or  less  contradictory:  it  must  reduce  labor  to  a  minimum, 
but  it  must  not  omit  details  that  may  need  tracing;  it  must  be  so  ar- 
ranged that  the  bookkeeper  can  work  more  or  less  mechanically  — 


396  ACCOUNTS 

for  otherwise  rapidity  of  work  is  impossible, — and  this  means  that 
items  requiring  the  same  treatment  must  have  virtually  the  same  ap- 
pearance on  the  page,  and  not  many  exceptions  to  a  general  rule  can 
be  introduced.  Many  statistical  forms  are  required  in  modem  busi- 
ness, but  no  attempt  is  made  here  to  treat  the  principles  governing 
theh:  construction.  We  have  been  concerned  only  with  financial  forms 
and  with  suggestions  for  such  statistical  forms  as  may  be  often  well 
coupled  with  the  financial. 

III.   Certain  Common  Auxiliary  Books 

All  the  books  that  have  been  so  far  discussed  may  be  called  principal 
books,  for  we  may  say  of  each  of  them  that  if  it  is  used  at  all  no  state- 
ment of  the  financial  condition  of  the  business  and  of  its  relation  to  out- 
siders can  be  made  unless  all  items  are  taken  into  consideration  and 
classified,  or  posted.  Good  bookkeeping  has  other  purposes,  however, 
than  record  of  mere  financial  condition  and  personal  relation.  Numer- 
ous records  of  a  statistical  sort,  and  numerous  memoranda  to  serve  as 
reminders,  are  essential.  Such  books  are  usually  called  auxiliary,  for 
figures  from  them  do  not  usually  affect  the  ledger  or  the  balance  sheet. 
So  far  as  these  books  afford  means  of  making  allowances  and  estimates 
of  value  at  the  end  of  a  year,  however,  they  are  important  for  balance- 
sheet  purposes. 

The  most  common  of  these  books  is  the  so-called  bill-book,  for  re- 
cording the  details  of  bills  receivable  and  bills  payable.  Each  note 
may  well  be  given  a  number  [as  B.  R.  167,  B.  P.  115]  and  then  in  the 
principal  books  detailed  reference  other  than  by  number  becomes  un- 
necessary. Besides  columns  for  recording  the  names  of  maker,  payer, 
endorser,  the  date,  the  amount,  the  amount  of  interest,  etc.,  of  each 
note,  these  books  provide  a  means  of  jogging  the  memory  of  a  business 
man  as  to  the  date  at  which  notes  become  due.  The  device  in  its  sim- 
plest form  consists  of  twelve  columns,  one  for  each  month  of  the  year, 
with  room  enough  in  each  column  to  write  a  number  to  designate  a  day. 
On  the  line  devoted  to  each  note,  therefore,  an  entry  is  made  in  the 
proper  column  to  designate  the  day  of  maturity.  A  glance  down  the 
column  shows  on  what  days  in  any  month  notes  mature,  and  a  glance 
along  the  lines  in  which  numbers  occur  shows  which  notes  mature  on 
those  days.  When  days  of  grace  are  allowed,  two  numbers  are  used 
Thus: 


APPENDIX  A  397 


Jan.  Feb.  March  April 

23/26 

11/14 


31 


10 


When  notes  are  numerous  and  danger  of  oversight  exists  in  having 
many  in  the  same  column,  two,  three,  or  four  columns  may  be  provided 
for  each  month,  headed:  1-15,  16-30;  or  i-io,  11-20,  21-31;  or  1-7, 
8-15,  16-23,  24-31- 

This  sort  of  device  may  take  many  forms,  and  may  be  adapted  to  many 
uses.  A  common  use  besides  that  for  notes  payable  and  notes  receivable 
is  for  accounts  payable  and  accounts  receivable.  Where,  as  in  many  trades, 
large  discounts  are  allowed  for  the  payment  of  bills  before  certain  dates, 
a  shrewd  manager  will  never  allow  one  of  those  discount  days  to  escape 
his  notice.  A  book  for  accounts  payable  arranged  on  this  plan  is  almost 
a  necessity.  As  a  means  of  watching  the  standing  of  customers,  too,  a  book 
for  accounts  receivable  is  a  great  convenience. 

In  banks,  where  notes  are  likely  to  be  very  numerous,  a  different  form 
of  memorandum  is  usually  adopted.  In  addition  to  the  discount  register 
and  the  collection  register,  described  on  pages  387  and  392,  most  banks 
keep  a  *' discount  tickler"  and  a  "collection  tickler,"  so-called,  —  de- 
signed to  tickle  the  memory.  In  these  ticklers,  a  space  of  several  or  many 
lines  is  provided  for  each  day  of  the  year,  and  as  soon  as  a  note  is  taken 
its  record  is  entered  in  the  space  provided  for  the  day  on  which  it  matures. 
Thus  no  excuse  can  exist  for  failure  to  present  it  for  payment  at  the  proper 
time. 

Other  com^mon  forms  of  auxiliary  books  are  of  a  ledger  type  —  such  as 
order  ledgers,  stock  ledgers,  and  stores  ledgers.  In  an  order  ledger  for 
manufacturing,  for  instance,  all  orders  are  entered  as  received,  and  as 
parts  of  the  order  are  shipped  entries  are  made  to  correspond;  so  that 
the  book  should  show  at  all  times  just  how  much  of  any  order  has  been 
filled  and  how  much  remains  unshipped.  Similarly,  a  stock  ledger  will 
be  arranged  by  kinds  of  goods  intended  to  be  kept  in  stock,  and  all  re- 
ceipts of  goods  and  all  shipments  will  be  entered  under  the  proper  heads; 
so  that  the  amount  of  each  kind  of  stock  on  hand  will  be  always  on  record. 
A  stores  ledger  serves  a  similar  purpose,  by  similar  method,  for  material 
and  other  supplies  intended  not  for  sale  but  for  use. 

Another  type  of  stock  ledger,  sometimes  called  a  "  stockholders'  ledger," 


398  ACCOUNTS 

is  of  interest.  Antedating  this  is  found  usually  at  the  inauguration  of  a 
corporation  a  book  called  the  "  installment  ledger,"  of  which,  though 
various  styles  are  in  use,  the  chief  purposes  are  sufficiently  indicated  by 
the  forms  below.  Stock  certificates,  unlike  bonds,  are  not  usually  issued 
to  represent  individual  shares,  but  to  represent  holdings.  A  single  cer- 
tificate may  represent  one  share  or  a  thousand  shares.  Consequently  a 
man  holding  a  certificate  for  one  hundred  shares  and  wishing  to  sell  fifty 
must  surrender  his  certificate  and  have  two  new  ones  issued ;  one  of  these 
he  can  then  transfer.  When  stock  has  been  subscribed  for  but  not  yet 
paid  for  in  full,  the  subscriber's  account  will  have  a  debit  balance  because 
he  owes  the  corporation;  this  shows  in  the  installment  ledger;  but  when 
his  payment  is  complete,  his  balance  is  transferred  to  the  credit  side,  on 
the  stock  ledger,  showing  the  corporation's  liability  to  him.  Often  stock  is 
transferred  when  only  some  of  the  installments  are  paid.  In  such  cases  the 
original  subscriber's  liability  for  the  rest  of  the  subscription  is  acquitted, 
and  the  new  subscriber  accepts  the  responsibility,  as  shown  on  page  399. 


APPENDIX  A 


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4) 


APPENDIX    B 

ADDITIONAL    ENTRIES,    TO    SUPPLEMENT   PART   I 

7.    Opening  the  Books  of  a  Corporation 

A  FEW  peculiarities  will  be  found  in  the  opening  of  the  books  of  a  cor- 
poration. 

The  stockholders  of  a  corporation,  as  already  explained,  do  not  usu- 
ally appear  by  name  upon  its  principal  books.  Hence  credit  is  not 
given  to  them  for  their  investment  as  it  is  given  to  a  proprietor  or  part- 
ner. The  account  to  represent  stockholders  is  Capital  Stock.  When  the 
capital  of  a  corporation  is  invested  in  a  lump  sum  in  cash,  the  entries 
are  intended  to  show  that  the  amount  is  original  investment,  and  hence 
subscriptions  are  recorded.  Otherwise  the  corporation  may  appear  to  be 
dealing  in  its  own  stock  —  which  is  sometimes  illegal.  The  first  entry, 
assuming  the  amount  of  payment  to  be  $100,000,  is 

Subscriptions  100,000 

To  Capital  Stock  Subscribed  100,000 

The  debit  indicates  an  asset  —  a  promise  to  pay.  The  credit  indicates 
a  liability  —  a  promise  on  the  part  of  the  corporation  to  issue  certifi- 
cates. Ordinarily  the  stock  should  not  be  issued  until  paid  for,  and  as 
the  capital  stock  account  should  represent  only  stock  certificates  actu- 
ally issued,  no  credit  should  be  made  to  Capital  Stock  until  subscriptions 
have  been  paid.  On  the  payment  of  cash  and  issue  of  stock  two  new 
entries  are  required.  The  first  explains  the  origin  of  the  cash,  and  the 
second  shows  the  fulfillment  of  the  corporation's  liability. 

Cash  100,000 

To  Subscriptions  100,000 

Capital  Stock  Subscribed  100,000 

To  Capital  Stock  100,000 

The  net  effect  of  these  three  entries  is  simply  a  debit  to  Cash  and  a 
credit  to  Capital  Stock. 

Usually  subscriptions  are  payable  in  installments.  Then  an  account 
is  kept  with  each  installment  and  we  may  have  this  entry; 


402  ACCOUNTS 

Subscriptions  Installment  #i  50,000 

Subscriptions  Installment  #2  50,000 

To  Stock  Subscribed  100,000 

When  the  first  of  these  installments  is  paid,  cash  is  debited  and  the  in- 
stallment account  is  credited.  If  no  stock  is  issued  until  paid  for  in  full, 
no  further  entry  is  necessary  at  this  time,  for  on  no  share  of  stock  has 
full  payment  yet  been  made.  When  payment  has  been  completed,  how- 
ever, and  the  second  installment  has  been  credited,  a  new  entry  debiting 
Stock  Subscribed  and  crediting  Capital  Stock,  as  already  indicated  for 
payment  in  one  lump  sum,  will  show  the  fulfillment  of  the  obligation  on 
the  part  of  the  corporation. 

Stock  subscribed  for  at  a  premium  introduces  a  new  element.  Since 
the  amount  of  stock  issued  is  less  than  the  amount  to  be  paid,  and  the 
capital  stock  account  should  register  only  the  face  value  of  certificates 
issued,  another  credit  must  be  found.  As  a  matter  of  fact  this  extra 
amount  is  as  much  capital  investment  as  is  the  amount  of  par  value  paid: 
that  is,  if  stock  is  issued  at  no,  the  last  ten  dollars  is  as  much  invest- 
ment of  a  stockholder  as  is  the  first  one  hundred,  and  it  must  be  shown 
as  investment.  It  is  in  no  sense  profit :  it  is  no  more  profit  than  is  the  first 
ten  dollars;  it  must  be  shown  on  the  books,  then,  as  capital.  Since  it  can- 
not go  to  Capital  Stock,  it  should  go  to  Capital  Surplus  —  or  Premium 
Surplus.  Since  the  latter  term  shows  the  exact  origin  of  the  surplus,  it 
is  preferable  to  the  former.  Good  accounting  requires  that  the  amount 
shall  remain  permanently  on  the  books  as  long  as  the  business  keeps  its 
entity,  for  that  amount  of  capital  is  to  be  accounted  for.  Even  though 
there  be  operating  losses,  and  hence  accumulated  deficits,  these  should 
not  be  allowed  on  the  books  to  wipe  out  premium  surpluses  —  or, 
rather,  premium  surpluses  should  not  be  used  to  wipe  out  operating  losses. 
So  to  apply  them  is  as  misleading  as  to  charge  revenue  items  to  capital, 
for  it  is  to  prevent  the  balance  sheet  from  showing  that  the  invested 
capital  has  been  depleted.  Even  if  the  loss  is  a  loss  of  capital  from  other 
causes  than  operation —perhaps  a  shrinkage  in  bond  values,  —  to  can- 
cel such  shrinkage  against  Premium  Surplus  would  be  bad  accounting. 
Preferably  both  the  surplus  and  the  deficit  should  show  on  the  books, 
for  they  have  absolutely  unrelated  origins.  We  may  even  have  this  ex- 
treme condition  on  a  trial  balance: 


APPENDIX   B 

Capital  Stock 

100,000 

Premium  Surplus 

10,000 

Operating  Deficit 

i       S,ooo 

Capital  Deficit 

5,000 

Net  assets 

100,000 

403 


110,000 


This  shows,  and  no  other  trial  balance  could  adequately  show,  that  the 
business  is  still  behind  the  game,  for  it  shows  no  assets  to  cover  the  pre- 
mium paid  on  its  stock;  to  avoid  the  conclusion  that  operations  de- 
stroyed those  assets,  the  two  deficits  should  be  kept  separate.  In  pub- 
lishing a  balance  sheet,  on  the  other  hand,  it  might  be  inadvisable  to 
show  the  items  in  this  way,  for  many  readers  would  see  the  surplus  but 
fail  to  see  the  deficits,  or  vice  versa.  The  clearest  form  would  be  to  show 
the  deficits  as  subtractions  from  the  premium  Surplus,  all  short-ex- 
tended on  the  liability  side;  the  result  would  show  that  though  there 
was  no  actual  surplus  or  deficit  above  or  below  the  par  value  of  stock, 
there  was  deficit  below  the  property  entrusted  to  the  business,  and  from 
two  causes. 

The  issue  of  stock  at  a  discount  is  not  quite  the  reverse  case,  for,  far 
from  being  a  preferable  permanency  in  the  accounts,  it  should  be  dis- 
posed of  not  only  on  the  books  but  as  a  fact  as  soon  as  possible.  Under 
some  State  laws  stock  may  not  be  issued  until  fully  paid.  No  such  thing 
as  the  issue  of  stock  at  a  discount  is  then,  at  least  in  form,  legally  possible. 
In  effect,  even  in  such  States,  the  sale  is  made  —  though  not  by  the  cor- 
poration —  and  may  be  made  with  perfect  honesty  both  of  spirit  and  of 
letter.  If  a  business  owns  property  that  the  proprietors  know  to  be 
highly  valuable,  even  though  they  know  that  they  cannot  necessarily 
convince  others  of  its  value,  they  may  incorporate  and  issue  stock  for 
that  honest  high  value.  The  stock  thereby  becomes  fully  paid.  The 
incorporators  may  now,  in  order  to  induce  others  to  take  shares  and 
furnish  more  capital  for  the  enterprise,  personally  give  of  their  shares, 
already  paid  for  and  issued  to  them,  to  the  new  subscribers.  The  later 
subscribers  get  possibly  five  shares  of  stock  for  the  par  value  of  four;  but 
they  get  only  four  from  the  corporation  (in  return  for  the  cash  payment, 
at  par,  for  four)  and  one  from  other  stockholders.  The  corporation  in 
this  case  is  not  issuing  any  stock  at  below  par,  and  it  is  not  concerned 
with  any  private  transactions  by  which  original  stockholders  induce 
later  subscribers  to  take  shares.  If  the  original  property,  for  which  the 


404  ACCOUNTS 

first  stock  was  issued,  is  not  overvalued,  this  savors  nowhere  of  irregu- 
larity or  of  moral  laxity.  In  effect  the  first  stockholders  are  buying  their 
stock  at  a  premium,  and  thus  invest  what  the  others  in  effect  do  not  in- 
vest; for  they  have  contributed  possibly  $100,000  in  property,  but  now 
hold  in  stock  (if  they  have  donated  $10,000)  only  $90,000  in  compen- 
sation. Often  it  is  worth  their  while  to  make  this  arrangement,  for  they 
have  sufficient  grounds  for  faith  that  the  earning  capacity  of  the  prop- 
erty, with  the  increased  capital,  will  soon  yield  them  large  dividends 
even  on  the  stock  held  virtually  at  a  premium. 

Sometimes  the  donation  of  stock  as  an  inducement  to  buy  new  stock 
goes  through  the  treasury  of  the  corporation.  Then  it  must  appear  on 
the  books.  The  first  entry  should  show  that  the  stock  is  held  as  a  gift, 
and  therefore,  since  it  has  been  once  fully  paid,  may  be  sold  for  what  it 
will  bring,  as  may  any  property.  A  debit  to  Donated  Stock  and  a  credit 
to  Donated  Surplus  will  accomplish  this.  Many  prefer  to  call  the  asset 
account  simply  Treasury  Stock,  ^  undistinguished  from  other  stock  once 
issued  but  again  held  by  the  corporation.  Such  stock  should  be  entered 
at  par  value,  for  since  the  actual  value  is  governed  by  the  same  laws  as 
those  governing  capital  stock,  it  should  appear  on  the  books  at  the  same 
rate  as  capital  stock.  This  Donated  Surplus,  unlike  Premium  Surplus, 
does  not  represent  investment,  and  hence  is  not  necessarily  permanent. 
It  is  a  nominal  account  explaining  the  asset  of  the  donated  stock,  and 
it  should  have  just  as  much  permanence  as  the  assets  yielded  by  the 
donation.  When  this  donated  stock  is  sold.  Donated  Stock  will  be  cred- 
ited for  the  par  value  of  that  sold.  Cash  will  be  debited  for  the  amount 

1  In  good  accounting  practice  the  term  "treasury  stock"  is  applied  only  to  stock 
once  actually  issued  but  now  owned  by  the  corporation.  Often,  however,  corporations 
use  the  term  for  stock  authorized  though  never  issued.  If  the  corporation  desires  to 
show  authorized,  but  unsubscribed,  stock  on  its  balance  sheet,  it  should  show  the 
contra  item  as  Unsubscribed  Stock.  A  complete  set  of  entries  may  be  made  to  get  such 
items  on  the  books.  For  example,  at  the  time  of  organization,  the  entry  would  be 

Unsubscribed  Stock 

To  Unsubscribed  Stock  Authorized 

Then  on  entry  of  subscriptions,  an  additional  entry  (reversed  from  that  above)  would 
be  required  to  reduce  both  the  unsubscribed  stock  and  the  imsubscribed  authoriza- 
tion. Though  it  may  be  convenient  to  carry  these  accounts  on  the  books,  for  assur- 
ance that  stock  shall  not  be  issued  or  subscribed  in  excess  of  authorization,  no  virtue 
lies  in  presenting  them  on  the  balance  sheet.  They  are  memorandum  rather  than 
financial  accounts.  A  footnote  to  the  balance  sheet,  showing  total  capital  stock  au- 
thorized, would  serve  every  balance-sheet  purpose  and  be  less  likely  to  mislead  than 
would  a  figure  of  unissued  stock  as  an  asset  of  apparently  full  validity. 


APPENDIX  B  405 

received,  and  Donated  Surplus  will  be  debited  for  any  discount.  The 
balance  of  Donated  Surplus  will  then  show  the  real  value  of  the  gift. 
It  may  be  closed  into  Capital  Surplus,  for  it  is  a  capital  gain;  but  it 
should  not  be  closed  into  Operating  Surplus  lest  it  be  distributed  as 
dividends.  If,  for  example,  $10,000  in  stock  was  donated  and  was  then 
sold  at  80,  we  should  have  these  entries: 

Donated  Stock  10,000 

To  Donated  Surplus  10,000 

Cash  8,000 

Donated  Surplus  2,000 

To  Donated  Stock  10,000 

The  balance  of  Donated  Surplus  shows  a  net  gift  of  $8,000.  In  effect, 
then,  supposing  the  corporation  originally  issued  $100,000  of  stock  for 
the  property,  it  would  have  $108,000  of  property  for  $100,000  of  stock 
—  an  average  issue  at  a  premium  in  spite  of  the  sale  of  a  part  at  a  dis- 
count. This  transaction,  like  the  other,  is  perfectly  regular  if  the  origi- 
nal property  is  not  overvalued.  If,  on  the  other  hand,  the  original  prop- 
erty were  actually  worth  only  $90,000,  so  that  the  donation  cost  the 
donors  nothing,  the  corporation  would  get  only  $98,000  altogether  for 
$100,000  in  stock.  When  property  is  overvalued,  recourse  may  be 
had  in  case  of  bankruptcy  against  the  directors  or  corporators  for  issu- 
ing stock  in  excess  of  the  value  of  the  property  surrendered;  but  often 
they  escape  penalty  because  the  burden  of  proof  put  upon  the  plaintiff, 
to  show  that  the  property  was  willfully  overvalued,  is  too  heavy. 

If  in  States  where  stock  need  not  be  fully  paid  an  issue  is  made  at  less 
than  par,  or  before  all  subscriptions  have  been  paid,  the  books  must 
show  the  deficiency  —  either  as  Discount  on  Stock  Issued  or  as  Sub- 
scriptions Unpaid,  —  and  stockholders  are  liable  for  assessment  and 
judgment  to  make  up  the  balance.  Profits  of  operation  and  capital  gains, 
however,  may  be  applied  to  such  deficiencies  and  render  the  stock  fully 
paid.  This  process  consists  simply  in  transferring  such  siupluses  to  the 
accounts  showing  deficiency,  thus  closing  them. 

When  the  capitalization  is  based  on  a  recognizable  good  will  of  a 
former  owner  of  a  business,  an  entry  may  be  made  to  cover  that  item. 
If,  for  example,  a  corporation  succeeds  a  proprietorship,  and  the  pro- 
prietor is  given  a  share  of  stock  representing,  on  account  of  the  value  of 
his  reputation,  more  than  the  actual  sale  value  of  his  merchandise,  plant, 
etc.,  the  books  may  well  show  the  excess  of  stock  as  issued  in  pajTnent 
for  good  will.  Thus,  if  Joseph  Sedley  has  a  capital  shown  by  his  books  to 


4o6  ACCOUNTS 

the  amount  of  $50,000,  and  his  average  profit  is  $10,000  (above  compen- 
sation for  his  superintendence),  it  is  obvious  that  his  particular  situation, 
or  reputation,  or  combination  of  circumstances,  affords  him  unusual  op- 
portunity for  profit.  Any  corporation  desiring  to  buy  his  business  must 
pay  for  those  advantages.  Suppose  it  is  probable  that  an  additional  capital 
of  $100,000  will  enable  the  business  to  increase  its  earnings  to  $18,000; 
i.e. J  a  new  $100,000  will  earn  $8000  for  itself,  and  still  leave  $10,000 
for  Joseph  Sedley.  Ordinarily  Sedley  will  not  care  to  sell  unless  he  can 
be  assured  of  his  $10,000,  and  the  corporation  must  give  him  enough 
stock  to  assure  that  income.  Under  such  circumstances,  if  the  corpora- 
tion can  show  a  prospect  of  paying  8%,  it  must  issue  to  Sedley  stock  to 
the  value  of  $125,000  to  induce  him  to  sell.  Even  then  he  may  find  no 
inducement  unless  the  probabilities  of  success  are  greater  under  the  cor- 
poration than  under  the  proprietorship.  If  he  agrees  to  the  sale,  and  the 
corporation  takes  over  his  business  entire,  claims,  debts,  stock,  plant, 
etc.,  the  only  entries  necessary  are  for  the  transfer  of  the  proprietorship 
and  the  issue  of  stock.  These  would  be  as  follows: 

Gcx)d  Will  75,000 

To  Joseph  Sedley  75.ooo 

Estimated  value  of  his  business  as  a  whole,  in  excess 
of  the  valuation  of  the  property  and  claims 

When  this  is  posted,  the  books  show  Sedley's  credit  to  be  $125,000; 
for  his  present  worth  was  previously  shown  to  be  $50,000. 

When  subscriptions  are  asked  for,  Sedley's  is  treated  like  any  one's 
else,  included  in  the  following  (18,000  is  8%  of  225,000): 

Subscription  225,000 

To  Capital  Stock  Subscribed  225,000 

When  Sedley  transfers  the  title  to  his  business,  and  receives  stock, 
the  first  entry  is  simply 

Joseph  Sedley  125,000 

To  Subscription  125,000 

Now,  on  the  ledger,  Sedley's  private  account  is  closed;  for  his  debits 
and  his  credits  are  equal.  He  no  longer  as  an  individual  has  interest  in 
the  business;  his  claim  is  as  a  holder  of  stock,  and  as  such  his  name  ap- 
pears not  on  the  general  ledger,  but  only  on  the  stock  ledger  —  an  aux- 
iliary book  showing  who  may  vote  at  meetings  and  to  whom  dividends 


APPENDIX  B 


407 


shall  be  paid.  The  only  reason  that  his  name  appears  on  the  journal  as 
a  purchaser  of  stock,  while  no  other  stockholder's  name  need  be  entered 
on  the  general  ledger,  is  that  his  payment  for  stock  is  by  means  of  the 
surrender  of  a  claim  already  entered  against  the  business  —  which,  of 
course,  must  be  cancelled  —  while  other  subscribers  pay  new  property 
into  the  business.  The  issue  of  stock  is  entered  as  before,  by  a  debit  to 
Stock  Subscribed  and  a  credit  to  Capital  Stock, 

II.  Another  Method  of  Closing  Books 

A  method  of  closing  books  different  from  that  shown  in  Chapter  V  is 

worthy  of  comment.   In  this  method  no  transfers  are  made  direct  upon 

the  ledger,  but  journal  entries  are  made  for  each  item  carried  from  one 

account  to  another,  and  full  details  of  inventories  may  be  shown. 

The  method  of  closing  an  account  with  accrued  items  is  as  follows: 


Dec.  31 


0 

Interest 

5 

To  Loss  and  Gain 
To  close,  as  follows: 

Accrued  credits 

B.  R. 

#247 
294 
296 
310 

$53 
34 
26 

31 

325 

»3 

227 

Accrued  debits 

B.  P. 

#49 
54 

IS 
48 

72 

64 

127 

Accrued  credit  balance 

100 

Net  receipts,  per  ledger 

600 

700 


700 


700 

When  this  item  has  been  posted,  the  balance  of  the  interest  account  will 
be  $100  on  the  debit  side,  properly  representing  $100  that  next  year's 
business  is  responsible  to  collect.  This  result  is  the  same  as  that  attained 
by  the  method  given  in  Chapter  V,  page  49. 

Similarly,  Merchandise,  with  a  summary  inventory,  may  be  closed  with 
the  net  profit  carried  to  Loss  and  Gain  and  the  inventory  left  as  a  balance 
for  the  new  year,  thus: 


4o8 

ACCOUNTS 

Dec.  31 

II 

Merchandise 

25 

To  Loss  and  Gain 
To  close,  as  follows: 

Stock,  dry  goods 

10,000 

millinery 

3,000 

shoes 

7,000     20,000 

Credit  balance,  per  k 

dger         10,000 

30,000 


30,000 


The  posting  of  this  item  gives  the  account  a  debit  balance  for  the  new 
year  of  $20,000  as  on  page  48. 

It  would  be  possible,  of  course,  to  split  these  entries  and  enter  only  the 
inventories  or  the  accrued  items  in  this  way,  crediting  or  debiting  them 
by  simple  journal  entries.  Then  the  balance  of  net  profit  or  loss  could  be 
transferred  to  Loss  and  Gain  by  the  other  method,  as  described  in  Chap- 
ter V. 

Indeed,  as  ahready  indicated,  it  is  often  convenient  to  carry  invento- 
ries on  the  books  in  special  accounts.  In  such  cases  entries  would  be 
made  crediting  the  accounts  which  contained  the  inventories  and  debit- 
ing Inventory.  For  example,  the  first  entry,  say  Dec.  31,  would  read: 


Merchandise  Inventory,  Dec.  31,  1915 
To  Merchandise 


20,000 


20,000 


Then  the  balance  of  Merchandise  would  show  the  gross  profit  on  mer- 
chandise, for  the  account  would  be  purely  nominal.  At  the  end  of  the 
next  year,  Merchandise  should  be  debited  for  the  amount  of  Merchan- 
dise Inventory  as  entered  above,  and  the  inventory  account  should  be 
credited  and  thus  closed.  Then  a  new  entry  would  be  made  for  the 
amount  of  inventory  at  that  later  date,  again  crediting  Merchandise  and 
debiting  Merchandise  Inventory.  So  the  process  would  be  repeated, 
each  year  making  Merchandise  a  pure  nominal  account  and  closing  it 
in  that  condition.  If  Purchases  and  Sales  are  kept  separately,  as  previ- 
ously suggested,  these  two  accounts  and  Merchandise  Inventory  would 
be  brought  together  in  the  one  summary  Merchandise  account,  and  this 
would  have  no  entries  except  at  the  time  of  closing  the  books.  It  would 
be  a  clearing  account. 

Accounts  having  no  inventory  or  accrued  items  attached  may  be  closed 
into  Loss  and  Gain  by  a  simple  debit  or  credit  on  the  journal  to  transfer 
the  balance. 

In  the  case  of  Real  Estate  and  Plant,  if,  as  may  happen,  the  bookkeeper 
wishes  to  keep  an  account  to  represent  depreciation  year  by  year,  so  that 


APPENDIX   B  409 

the  amount  can  be  found  at  a  glance  without  picking  it  out  from  the 
various  items  of  the  real  estate  and  plant  account,  two  journal  entries 
may  be  used.  The  first  records  the  depreciation. 

Depreciation  1626.00 

To  Real  Estate  and  Plant  1626.00 

The  second  transfers  the  depreciation  to  Loss  and  Gain.  When  that  has 
been  done,  Depreciation  is  closed,  Real  Estate  and  Plant  shows  the  proper 
balance,  and  the  loss  is  correctly  reported;  and  the  entries  to  Depre- 
ciation show  in  convenient  form  just  what  has  been  charged  on  that 
account  each  year.  As  many  depreciation  accounts  may  be  distinguished 
as  one  may  wish. 

Finally,  Loss  and  Gain  is  closed  by  journal  entries  which  carry  the  bal- 
ance to  the  proprietors  or  to  dividends,  or  to  surplus,  or  what  not. 

Of  the  various  methods  of  closing  discussed,  all  produce  not  only  the 
same  result  on  the  ledger  but  virtually  the  same  appearance:  direct  clos- 
ing, by  simple  transfer  on  the  ledger,  is  the  simplest  and  quickest;  jour- 
nal closing  is  more  formal  and  more  obvious  to  one  unacquainted  with 
bookkeeping;  inventory  closing  through  the  journal  is  the  most  laborious 
and  distinguishes  more  clearly  in  form,  though  not  in  principle,  between 
real  and  nominal  accounts.  The  choice  between  these  methods  is  one  of 
laste.  If  record  is  kept  of  all  matters  entering  into  inventories  and  into 
allowances  for  accrued  and  prepaid  items,  the  direct  method  of  closing 
has  all  the  advantages  of  the  others  and  none  of  their  disadvantages. 
Such  memoranda  may  actually  be  made  in  the  journal,  as  memoranda 
and  not  as  entries,  and  thus  preserve  full  explanation  of  the  origin  of 
the  amounts;  but  Uttle  more  labor  is  required,  however,  to  make  com- 
plete entries  from  these  memoranda.  One  great  convenience  of  the  direct 
closing,  when  red  ink  is  used  for  transfers,  is  the  clearness  with  which 
final  transferred  balances  stand  out  before  the  eye  when  for  any  reason 
they  are  sought.  Only  a  technical  objection  could  be  raised,  however, 
to  putting  these  in  red  if  they  were  posted  from  journal  entries. 


APPENDIX  C 
SINGLE  ENTRY 

Throughout  this  book  double  entry  has  been  assumed  as  the  only  cor- 
rect system  of  bookkeeping.  The  reason  was  explained  in  Chapter  II. 
A  few  words  about  the  single-entry  system  may  be  interesting,  though 
they  can  serve  little  purpose  except  to  emphasize  the  advantage  of  the 
other. 

The  fundamental  distinction  is  that  theoretically  single  entry  has  none 
but  personal  accounts.  When  a  transaction  involves  two  such  accounts, 
the  entry  is  necessarily  double,  a  credit  to  one  and  a  debit  to  the  other. 
If,  for  instance,  we  owe  Jones  and  pay  him  by  an  order  on  Smith  who 
owes  us,  we  must  debit  Jones  and  credit  Smith.  Theoretically,  by  single 
entry  this  would  be  made  as  two  entries: 

J.  Jones,  Dr.       2,500 

Paid  him  by  an  order  on  J.  Smith 

J.  Smith  Cr.       2,500 

By  an  order  to  pay  J.  Jones  for  our  account 

In  practice,  however,  these  are  often  combined  as  in  a  double-entry 
journal,  though  the  double  form  intervening  between  single  forms  is  more 
or  less  dangerous,  since  the  bookkeeper  may  not  notice  that  here  two 
postings  are  required. 

It  is  not  strictly  in  accordance  with  the  single-entry  theory  to  keep  ac- 
counts with  property,  such  as  merchandise  and  cash,  though  it  is  cus- 
tomary to  do  so. 

When  expenditures  are  for  such  things  as  interest,  expense,  etc.,  the 
normal  entry  would  be  to  disregard  the  nominal  account  entirely  and  sim- 
ply credit  cash.  If,  however,  one  wished  to  keep  track  of  interest,  an  ac- 
count could  be  kept  with  it,  posting  to  it  as  under  the  other  system.  Just 
so  far,  however,  the  system  would  be  double  entry. 

Under  pure  single  entry,  therefore,  the  situation  is  as  follows :  the  books 
show  all  amounts  owing  and  all  amounts  owed;  the  resources  of  other 


APPENDIX   C  411 

sorts  may  be  counted  or  valued,  as  cash,  notes,  merchandise,  etc.  The 
difference  between  net  resources  and  net  liabilities  is  the  present  worth 
of  the  business  —  exactly  as  in  the  balance  sheet  by  double  entry.  A  com- 
parison of  this  year's  present  worth  with  last  year's  present  worth  (allow- 
ing for  any  supposed  profits  withdrawn  by  proprietors  or  as  dividends) 
shows  profit  for  the  year,  —  just  as  a  comparison  of  two  balance  sheets 
(with  allowance  for  supposed  profits  withdrawn)  shows  profits  under 
double  entry. 

So  far  as  single  entry  goes,  therefore,  it  attains  the  same  result  as 
double  entry.  We  must  note,  however,  what  is  missing.  In  Chapter  V 
we  saw  that  by  a  six-column  statement  we  derive  profits  by  two  methods, 
and  that  the  two  methods  must  show  the  same  result.  On  such  a  state- 
ment we  compare  not  only  resources  and  liabilities,  but  also  losses  and 
gains.  We  know  not  only  how  much  we  have  made  and  what  it  cost,  but 
also  from  what  sources  we  made  it  and  how  the  cost  was  incurred.  Single 
entry  can  do  this,  to  be  sure,  by  keeping  extra  accounts;  but  so  far  as  it 
does  so  by  single-entry  methods  double  labor  is  involved.  In  double  entry, 
as  was  shown  in  Chapter  VI,  the  labor  is  not  only  not  double,  but  prac- 
tically single.  Indeed,  full  double  entry  by  double-entry  methods  is  far 
less  laborious  than  partial  double  entry  by  single-entry  methods. 

Profits  as  disclosed  by  single-entry  books  are  not  always  obvious. 
Suppose  our  books  and  inventories  give  us  the  following  figures:  pro- 
prietor's credit,  $40,000;  proprietor's  debit,  $3,000;  assets,  $70,000; 
liabilities,  $30,000.  Let  us  now  assume  that  the  only  entries  to  the  pro- 
prietor's account  are  his  present  worth  of  a  year  ago  less  any  with- 
drawals and  plus  any  new  investments  in  the  business.  Does  the  $3000 
debited  to  the  proprietor  represent  profits  withdrawn  or  capital  with- 
drawn? Has  the  proprietor  invested  more  in  the  business  since  a  year 
ago?  We  appear  to  need  answers  to  these  questions  before  we  can  learn 
profits;  for  if  the  proprietor  has  withdrawn  profits,  they  are  the  profits  of 
the  year,  and  must  be  included  in  the  final  figure  of  profits;  if  he  has 
withdrawn  capital,  the  investment  in  the  business  is  so  much  less  and 
hence  the  amount  of  profits  necessary  to  continue  the  present  worth  at 
the  old  figure  is  so  much  more;  if  he  has  invested  more,  the  increase  in 
assets  will  be  due  to  that  cause  and  not  to  profitable  operations.  Yet 
we  do  not  need  answers  to  any  of  these  questions.  If  the  proprietor's 
account  was  brought  to  date  at  the  last  closing  and  all  withdrawals  (of 
whatever  sort)  and  all  new  investments  have  been  entered  on  his  ac- 


412  ACCOUNTS 

count,  his  balance  is  what  the  business  now  stands  him  net:  any  excess 
over  this  is  profit,  any  deficiency  is  loss.  If  profits  have  been  already 
withdrawn,  that  is  a  question  not  of  the  amount  of  profits  but  of  their 
disposition.  If  the  present  worth  is  the  same  as  at  the  end  of  the  last 
period  and  $5000  has  been  withdrawn,  the  profits  have  been  $5000  — 
else  how  have  assets  got  back  to  the  old  figure?  If  the  present  worth  has 
risen  $5000,  but  $7000  has  been  invested,  the  loss  is  $2000  —  else  why 
has  not  the  present  worth  risen  by  $7000?  Except  for  profits  and  losses 
the  proprietor's  account  makes  due  allowance  for  all  items  affecting  the 
assets.  In  the  case  given  above,  since  the  proprietor's  balance  is  $37,000 
and  the  net  assets  are  $40,000  the  gain  is  $3000.  If,  then,  the  proprietor's 
account  is  closed  at  the  end  of  each  period  so  as  to  show  the  present 
worth,  and  all  withdrawals  and  new  investments  (and  nothing  else)  are 
carried  to  that  account,  we  have  the  rule  that  profits  or  losses  for  any 
period  are  disclosed  by  a  comparison  of  present  net  assets  with  proprie- 
tor's balance.  If  separate  accounts  are  kept  for  proprietor's  or  partners' 
withdrawals,  as  is  common,  the  balances  should  be  combined  with  the 
proprietors'  capital  balances  before  the  calculation  of  profits  is  under- 
taken. Any  balance  of  partners'  special  accoimts  for  salaries  and  inter- 
est may  be  disregarded  as  proprietorship  but  treated  as  asset  or  liability. 
This  is  the  shnplest  way  to  handle  them.  If,  however,  such  balances  are 
treated  as  proprietorship  rather  than  as  asset  or  liability  the  result  will 
be  the  same.  Suppose  we  have  partners'  credits  $40,000,  assets  $73,000, 
liabilities  $30,000,  partners'  salary  accounts  overdrawn  $1000,  and  part- 
ners' interest  accounts  with  a  credit  balance  of  $1000.  The  profits  are 
actually  $3000,  of  course.  If  we  treat  salary  overdraft  as  asset  and  in- 
terest as  liability,  net  investment  is  $40,000,  but  net  assets  are  $43,000. 
If  we  treat  salary  overdraft  as  asset  but  interest  as  capital,  the  net  in- 
vestment is  $41,000,  but  net  assets  are  $44,000.  If  we  treat  salary  over- 
draft as  capital  withdrawal  and  the  interest  as  liability,  we  get  net  m- 
vestment  as  $39,000,  but  net  assets  as  $42,000.  All  these  give  the  profit 
as  $3000;  for  when  salaries  and  interest  are  provided  for  under  the  part- 
nership agreement,  they  are  not  a  part  of  the  profits  but  costs  deducted 
from  product.  Balances  on  partners'  special  accounts,  then,  may  be 
treated  as  either  assets  and  liabilities,  on  one  hand,  or  proprietorship, 
on  the  other;  but  under  single  entry  they  must  not  be  treated  as  both. 


APPENDIX  D 

LOOSE-LEAF    SYSTEMS 

The  most  recent  improvement  in  bookkeeping  methods,  the  so-called 
loose-leaf  systems,  has  been  very  much  advertised  and  widely  adopted. 
In  one  sense  there  is  very  little  to  say  about  it  on  either  side.  It  is  not  a 
new  method  of  making  entries,  but  simply  a  device  by  which  sheets  may 
be  inserted  or  removed,  somewhat  as  cards  are  treated  in  a  library  card- 
catalogue,  and  then  locked  into  place  so  that  no  one  without  the  key  or 
combination  can  remove  or  insert  any. 

The  great  advantages  are,  of  course,  first,  the  removal  of  dead  matter, 
so  that  no  blank  or  closed  pages  need  to  be  turned,  and,  second,  bills  may 
be  made  in  duplicate  and  a  copy  inserted  to  save  writing.  There  prac- 
tically the  advantage  stops.  The  only  objection  to  the  system,  on  the  other 
hand,  is  the  rather  obvious  one  that  so  far  as  substitution  of  new  sheets 
for  old  ones  is  possible  the  books  have  lost  much  value  as  evidence  in  case 
of  dispute.  The  possibility  of  substitution,  however,  is  not  so  great  as  at 
first  thought  might  appear.  It  has  been  noted  in  the  discussions  of  Part 
I  that  commonly  an  item  is  included  in  totals  which  are  carried  from 
book  to  book,  ending  usually  in  the  ledger,  and  the  ledger  total  or  bal- 
ance is  likely  to  be  included  in  the  trial  balance  or  balance  sheet.  The 
substitution  of  a  new  incorrect  page  for  an  old  correct  page  —  that  is  to  say, 
forgery — would  be  likely  to  suffer  exposure  as  a  result  of  any  effort  to  trace 
it  through  the  books ;  for  the  falsified  figures  would  probably  be  included 
in  many  totals  or  give  rise  to  many  balances  on  many  different  pages. 
Only  a  substitution  of  new  pages  for  all  those  affected  by  the  change 
would  prevent  the  discovery  of  the  forgery;  for  each  of  these  changes 
would  probably  involve  new  ones  and  so  the  process  would  go  on  in 
a  practically  never-ending  chain,  —  except  for  matters  of  very  recent 
occurrence.  Practically  rewriting  the  whole  set  of  books  would  be  neces- 
sary to  make  successful  the  forgery  of  a  matter  several  months  old.  Yet, 
of  course,  sometimes  that  would  be  quite  as  well  worth  while  as  any  forgery 
is  worth  while.  When  it  comes  to  that,  however,  any  set  of  bound  books 
may  be  replaced  by  a  new  set.  The  possibility  of  detection  in  that  case 


414  ACCOUNTS 

depends  upon  the  fact  that  the  books  would  be  obviously  new,  whereas 
under  the  loose-leaf  system  the  individual  pages  do  not  usually  show  much 
wear. 

One  sort  of  entry,  however,  is  very  much  open  to  the  danger  of  forgery 
under  the  loose-leaf  system.  Journal  entries  are  usually  important  and 
usually  they  are  independent  of  other  entries.  That  is  to  say,  they  are 
not  usually  included  in  totals  as  are  figures  on  the  cash  book,  sales  book, 
purchase  book,  etc.  To  substitute  a  new  false  journal  page  for  an  old  one 
would  be  easy,  and  corresponding  ledger  pages  could  also  be  easily  sub- 
stituted, so  that  the  forgery  would  be  hard  to  detect.  For  this  reason  it 
is  common  to  use  a  journal  in  the  old-fashioned  bound  form. 

The  only  other  considerable  danger  in  the  use  of  the  loose-leaf  system 
is  that  some  detail  may  be  written  and  substituted  for  the  correct  detail, 
where  no  change  in  ultimate  amount  is  involved ;  for  since  only  totals  and 
balances  are  carried  through  a  set  of  books,  changes  in  detail  by  forged 
substitution  could  not  be  detected.  That  is  to  say,  if  the  dispute  were  not 
about  the  value  of  goods,  but  about  the  nature  or  quality  of  the  particular 
goods  ordered  or  shipped,  substitution  would  be  easily  possible. 

These  objections,  it  should  be  clearly  understood,  are  meant  to  imply 
not  that  many  business  houses  would  condone  forgery,  but  that  they 
wish  their  books  to  be  so  constructed  that  forgery  shall  be  practically 
and  obviously  impossible.  They  wish  to  avoid  not  merely  evil,  but  the 
possibility  and  the  appearance  of  evil. 

For  auxiliary  records,  such  as  ticklers,  detailed  cost  analyses,  etc., 
the  loose-leaf  systems  (or  card  systems)  are  extremely  valuable.  An 
office  force  using  them,  however,  must  be  trained  to  extreme  care  in 
handling  the  loose  elements,  for  the  misplacement  of  a  sheet  or  a  card 
is  usually  equivalent  to  the  loss  of  it. 


APPENDIX  E 

THE  TREATMENT  OF  PETTY  ACCOUNTS  AND  PETTY 

ITEMS 


In  the  text  of  Part  I  no  mention  was  made  of  what  are  commonly  called 
"petty  accounts."  These  are  of  a  minor  sort  not  requiring  a  separate 
space  for  each  in  the  ledger,  and  yet  needing  at  least  temporary  record. 
For  them  it  is  customary  to  keep  one  or  more  accounts  in  the  ledger 
called  "  Petty  Accounts,"  to  represent  the  whole  number,  or  a  whole  set, 
of  such  individual  accounts.  The  distinction  between  the  amounts  be- 
longing to  different  individuals  is  made  by  writing  the  name  as  a  part  of 
each  posting.  Balancing  is  accomplished  by  providing  that  each  debit  or 
credit  shall  be  posted  opposite  its  corresponding  credit  or  debit,  leaving 
blank  lines,  when  necessary,  to  allow  for  this.  A  sample  general-ledger 
page  might  look  as  follows : 

Petty  Accounts 


1907 
Nov.    7 

Dec.    2 
21 


1907 

H.  Smith 

29 

17-50 

Oct.  10 

H.  Smith 

17 

21 

J.  Jones 

19 

A.  Browne 

32 

22.00 

D.  Jones 

39 

164.00 

Dec.  12 

D.  Jones 

35 

17-50 

219.00 
164.00 


A  common  device  is  a  so-called  "petty  cash  book,"  maintained  not 
for  items  belonging  to  Petty  Accounts,  but  for  general  items  too  insig- 
nificant to  burden  the  general  cash  book.  Sometimes  money  is  placed  in 
lump  sum  in  the  hands  of  clerks  or  agents  for  disbursal  as  occasion  may 
require,  with  the  condition  that  they  shall  keep  detailed  cash  books. 

Petty  Cash  may  be  kept  under  various  plans.  The  most  obvious  is 
to  debit  Petty  Cash  on  the  general  cash  book  when  money  is  delivered 
to  the  petty-cash  drawer,  and  to  credit  Petty  Cash  and  debit  the  various 
disbursement  accounts,  in  lump  sums  at  intervals  on  the  journal,  after 
the  money  is  paid  out.  Then  the  balance  of  Petty  Cash  in  the  general 
ledger  should  always  agree  with  the  sum  of  the  petty  cash  in  the  drawer 
and  the  disbursements  recorded  in  the  petty-cash  book  but  not  yet  en- 
tered in  the  general  books. 


4l6  ACCOUNTS 

Another  plan  is  similar  but  enters  disbursements  in  lump  sum  at  in- 
tervals in  the  general  cash  book,  from  the  petty-cash  book,  and  gives 
credit  to  Petty  Cash  in  the  same  book  —  as  for  money  returned. 

A  plan  very  widely  adopted  of  late  is  called  the  **  impressed  "  system. 
Under  this  the  debit  to  Petty  Cash  is  as  before,  but  no  further  debits 
are  made  unless  it  becomes  desirable  to  increase  the  maximum  amount 
ever  held  in  the  petty-cash  drawer.  Replenishment  of  the  petty-cash 
drawer  is  made  by  giving  to  the  cashier  of  petty  cash  a  check  equaling 
in  amount  the  disbursements  made;  but  proper  charges  are  made  by 
entering  that  check  as  a  debit  not  to  Petty  Cash  but  to  the  accounts 
representing  the  expenditure  for  which  the  original  cash  was  disbursed. 
Thus  the  entry  in  the  general  cash  book,  though  made  at  the  time  of  the 
second  supply  of  cash,  is  charged  to  the  accounts  responsible  for  the  dis- 
bursement of  the  first  supply.  So  the  Petty  Cash  balance  on  the  general 
ledger  is  permanent  and  unchanging,  for  it  is  never  more  than  replenished 
and  each  replenishment  is  charged  not  to  it  but  to  the  accounts  which 
caused  it  to  be  depleted.  This  system  is  liked  by  auditors  because  the 
checks  for  replenishment  serve  as  vouchers  for  the  cash  devoted  to  the 
uses  of  petty  cash;  and  no  sums  should  be  allowed  to  get  into  petty  cash 
from  any  other  source. 

A  modern  development  of  the  device  of  Petty  Accounts  is  what  is 
called  the  "voucher  system,"  though  this  has  come  to  be  extended  to 
accounts  that  are  not  petty.  This  substitutes  for  the  general  ledger  ac- 
count of  the  other  system  an  account  called  "Vouchers  Payable."  In  the 
handling  of  items  for  this  account  two  books  are  usually  kept,  the  voucher 
book  and  the  vouchers  payable  register. 

The  voucher  book  consists  of  what  are  practically  bill-head  forms  bound 
together  so  as  to  be  detachable  from  a  printed  stub.  As  soon  as  a  pur- 
chase is  made,  a  form,  with  its  attached  stub,  is  filled  out.  The  form  shows 
all  details  of  the  transaction  (unless  it  is  so  complicated  that  an  invoice 
number  may  well  be  cited  instead),  and  the  stub  summarizes  the  trans- 
action with  the  additional  statement  of  how  the  items  are  to  be  treated 
on  the  books  of  the  paying  firm.  For  illustration,  if  a  department  store 
is  to  pay  an  advertising  bill,  the  voucher  will  be  filled  out,  in  detail,  to  be 
sent  to  the  publishing  office  with  the  payment,  and  the  stub  will  have  cor- 
responding information  summarized  with  the  additional  statement  of 
how  the  charge  is  to  be  divided  among  the  different  departments.  When 
the  voucher  is  sent,  a  request  is  made  that  it  be  signed  as  a  receipt  and 


APPENDIX  E  417 

returned.  If  it  does  not  return  in  due  season,  the  stub  serves  as  a  record, 
—  just  as  do  check-book  stubs.  The  presence  of  a  voucher  undetached 
in  the  voucher  book  indicates  that  the  bill  has  not  been  paid ;  so  the  book 
stands  as  a  whole  for  debts  outstanding. 

The  voucher  register  is  written  directly  from  the  voucher  book,  show* 
ing  totals  and  allocations  of  expenditure  somewhat  as  shown  on  page  418. 

At  the  end  of  each  day  or  week  or  month  the  totals  of  the  column  for 
amount  are  posted  to  the  credit  of  Vouchers  Payable  in  the  general  ledger 
and  the  amounts  of  the  separate  department  totals  are  debited  to  their 
proper  accounts.  Some  items  may  need  to  be  posted  individually  if  no 
special  columns  are  provided.  When  payments  are  made,  Vouchers  Pay- 
able is  debited  in  the  cash  book.  So  the  credit  balance  of  this  account 
in  the  general  ledger  should  always  agree  with  the  undetached  vouchers 
in  the  voucher  book  and  the  unpaid  items  in  the  voucher  register. 

With  some  business  houses  the  use  of  vouchers  is  carried  so  far  that 
they  take  the  place  of  the  common  form  of  bank  check,  for  the  vouchers 
contain  a  clause  ordering  a  bank  to  pay  the  bill.  This  is  convenient  for 
the  counting  room,  for  the  receipt  in  the  form  of  the  check  endorsement 
is  then  on  the  bill  itself  and  no  dispute  as  to  the  particular  items  covered 
by  it  can  possibly  arise.  Such  bulky  forms  of  check  are  extremely  incon- 
venient for  banks,  however. 

To  use  the  complete  voucher  system  for  all  payments,  as  some  firms 
do,  is  to  scatter  badly  the  transactions  with  one  concern  instead  of  keep- 
ing them  together  in  a  ledger;  and  so  it  can  be  recommended  only  for 
temporary  or  for  occasional  items.  For  such  items  an  alphabetical  card 
index  containing  the  names  of  all  creditors  and  the  numbers  of  all 
vouchers  relating  to  each  is  sometimes  a  convenience  for  reference.  The 
use  of  the  voucher  itseK  for  all  payments  seems  rather  like  system  gone 
to  seed,  for  ordinary  receipts,  receipted  bills,  and  endorsed  checks  are 
in  practically  all  cases  receipt  enough.  The  only  advantage  of  the  extra 
receipt  is  that  of  uniformity  for  filing  purposes.  In  effect,  the  account 
Vouchers  Payable  is  identical  in  nature  with  the  controlling  account 
Accounts  Payable  except  that  no  subordinate  ledger  gives  classified 
supporting  details. 

The  voucher  register  is  available  as  a  convenient  book  of  original  en- 
try even  when  no  voucher  book  or  special  voucher  form  is  used.  It  is 
then  simply  a  purchase  journal. 


4i8 


ACCOUNTS 


Pi 
W 

w 


1 

.2 

OO   00    M 

< 

8  8  8 

lo  6  "^ 

8 

1 

o  -s  2 

1 

'3 

o  o 

M 

1 

1 

3" 

1 

>      > 

1 

2^88 

Tj-     t4     lO     ■^ 
M     to    C    00 

00 

.•2 
<2 

O       vO   »0 

M           MM 

a 

M           t^    •^ 
M         MM 

4      4  4 

1 

M           t^ 

H     M     W 

4  4  4 

•S  -3  -3 

O   O   »o 

M     CO    M 

1 

2.  2.  s.  s      « 

1 

S  ^  "  2  2 
»  ^  -g  ft,  ~  8 

S  ^  S  <£      ;2 

5 

6 

5 

O   M   «   to   1 

M    M    M    M    1 
C^    t^    t^    t^    1 

s. 


op"a  tn  •"• 
0  o  «J  h 

O  4;  c<3  « 
O  .tS  ^  d 

•^  (U  <U  O 
15  g^-^'- 
o  »;=*='-' 
*^  ti  *^  o 

0) 


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a     .0  g 


Sil5 

flj  ■»-'  y  0)  5 

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H  o  <u  o  t^ 

^43   O   to 


APPENDIX  F 

FORMULAE 

In  many  of  the  following  formulae  several  differing  expressions  for  the 
same  thing  have  been  given.  When  good  tables  of  interest,  discount,  etc., 
are  at  hand,  simplified  formulae  are  desirable;  but  when  such  tables  are 
not  available,  only  the  most  detailed  formulae  are  serviceable.  The  most 
condensed  form  is  usually  given  first.* 

To  find  the  amount  {principal  and  interest)  of  a  sum  at  compound 
interest  for  a  number  of  periods 
Let  P  =  the  principal  sum 

f  =  the  rate  of  interest  per  period 

*  For  those  not  familiar  with  algebraic  expressions,  it  may  be  necessary  to  offer 
a  few  explanations.  Two  symbols  written  side  by  side  on  the  same  line  without  a 
sign  between  them  are  always  to  be  multiplied  together;  thus,  aP  means  the  amount 
of  a  multiplied  by  the  amount  of  P.  Pa  is  the  same  thing  as  aP,  of  course.  A  paren- 
thesis includes  all  within  it  as  one  item  subject  to  the  same  treatment  throughout; 
and  hence  P{a+i)  means  that  P  is  to  be  multiplied  not  only  by  a  but  also  by  i, 
giving  Pa+P,  not  Pa+  r.  When  two  symbols  are  written  as  a  fraction,  the  upper  is 

to  be  divided  by  the  lower;  thus  —  means  that  17  is  to  be  multiplied  by  d  and  the 

product  divided  by  r.  A  small  figure  or  symbol  written  at  the  right  and  above  another 
indicates  that  the  latter  is  to  be  multiplied  by  itself  as  many  times  as  the  number 
indicated  by  the  former:  thus,  a^  =  aXa\  a^=aXaXa;  (a  +  by  =  (a  +  b)X{a  +  b), 
ora'  +  2a&+62;  a''=aXaXaXa  etc.  as  many  times  as  there  are  units  in  p,  so  that  if 
fl  =  3  and  p  =  4,  0^=3X3X3X3.  A  similar  small  figure  written  in  fractional  form 
means  that  the  corresponding  root  is  to  be  taken,  —  that  is,  a  number  is  to  be  taken 
which  when  multiplied  by  itself  the  required  number  of  times  will  produce  the  re- 
quired amount ;  thus,  a*  =  the  cube  root  of  a.  Since  in  any  equation  the  two  halves 
are  equal,  as  6+4-^7  =  9-1-3-^5,  any  sum  may  be  subtracted  from  either  side  if  a 
corresponding  sum  is  subtracted  from  the  other  side,  or  such  sums  may  be  added,  or 
both  sides  may  be  divided  by  the  same  sum,  or  both  sides  may  be  multiplied  by  the 

same  sum:  thus,  if  A  =  i  +  r,  A  —  i  =  r,  and  ^4  + i=2+f;  if  A=Pa^i  '^=<^,  and 
-  =P;  and  if  JW  =  ^,  Mr^Ud. 


420  ACCOUNTS 

a  =  the  amount  of  one  dollar  for  one  period  (one  plus  the  rate*) 

p  =  the  number  of  periods 

A  =  the  amount  of  the  principal  for  the  specified  periods 

In  one  period  the  amount  of  one  dollar  will  be  i  +  r.  Since  interest  is 
here  compounded  annually,  in  the  second  period  the  sum  at  interest  is 
i  +  r,  and  at  the  end  of  the  period  it  will  be  not  only  intact  (that  is, 
multiplied  by  i),  but  increased  by  r  times  itself  (that  is,  be  multiplied  by 
I  +  r).  For  two  periods,  then,  the  amount  of  one  dollar  is  (i  +  r)  x  (i  +  r), 
or  (i  +  r)2.  In  the  third  period  this  amount  is  again  increased  by  (i  +  r) 
times  itself,  or  becomes  (i  +  r)'.  So  for  any  number  of  periods  i  +  r 
must  be  raised  to  the  power  corresponding  with  the  number  of  periods, 
or  (i  +  r)P.  Since  by  our  supposition  a  =  i  +  r,  the  amount  of  one  dollar 
for  any  number  of  periods  is  a^.  Then  Pa^,  or  the  amount  of  one  dollar 
multiplied  by  the  number  of  dollars  of  principal,  will  be  the  required  sum, 
the  amount  of  the  specified  principal  for  the  specified  periods  at  the  speci- 
fied rate. 

Formula  I.  .4  =  Pa^ 

To  find  what  principal  will  amount  to  a  given  sum  at  compound  interest 
in  a  given  number  of  periods 

This  problem  is  simply  the  reverse  of  the  last.  If  P  becomes  A  when 
multiplied  by  a^,  then  A  must  become  P  when  divided  by  a^;  or,  to  ex- 
press it  mathematically,  if  the  principal  multiplied  by  the  amount  of  $i 
gives  the  amount  accumulated  by  the  principal  in  a  number  of  periods, 
the  amount  desired  divided  by  the  amount  of  $i  must  give  the  principal 
required.  We  have  already  seen  that  the  amount  of  $i  for  any  number 
of  periods  is  a^. 

Formula  II.    P  =  -i 
a' 

To  find  the  present  worth  of  a  sum  payable  at  a  stated  time  in  the  future 
This  is  similar  to  the  last  problem  except  that  we  have  slightly  differ- 
ent names  for  the  same  figures.  In  the  last  case,  the  principal  was  the 
sum  invested  at  the  beginning  of  the  time.  Here  the  purpose  is  to  learn 
the  present  value  of  a  principal  that  is  payable  only  after  a  lapse  of  time, 
as,  for  example,  the  face  of  a  note  or  a  bond.   What  in  the  last  case  we 

*  The  rate,  of  course,  though  usually  spoken  of  as  if  it  were  units,  as  3,  4,  5,  etc.,  is 
really  hundredths.  Thus  a  rate  of  3  is  mathematically  .03.  So  one  plus  the  rate  is  m 
that  case  not  4,  but  1.03,  which  is  the  amount  of  one  dollar  for  one  year. 


I 


APPENDIX    F  421 

called  amount,  then,  becomes  here  the  principal,  and  what  was  principal 
becomes  here  present  worth. 
Let  W=the  present  worth. 

Formula  III.   W=  — 
a" 


To  find  the  compound  interest 

Here  the  problem  is  simply  to  subtract  the  principal,  or  initial  invest- 
ment, from  the  total  sum  accumulated,  or  amount. 
Let  i=the  compound  interest  of  one  dollar  for  the  periods  specified 
/=the  compound  interest  of  the  principal  sum  for  the   periods 
specified 
Then,  by  the  explanation  given  for  Formula  I,  we  get 

Formula  IV.  i  =  a''—  i 

/  =  i4-PorP(a''-i) 


To  find  the  compound  discount 

This  is  related  to  discount  as  the  fourth  formula  is  related  to  interest 
The  discount  is  the  principal  minus  the  present  worth. 
Let  d=the  compound  discount  of  one  dollar  for  the  periods  speci- 
fied 
D=the  compound  discount  of  the  principal  sum  for  the  periods 
specified 
Then,  by  the  explanation  for  Formula  III,  we  get 

Formula  V.   d  =  i 

a" 

JD  =  P- FT  or  P-— or  P  (I -— ) 
a"  oT 


To  find  the  amount  of  an  annuity 

The  mathematical  characteristic  of  an  annuity  is  that  the  sum  at  in^ 
terest  is  changing  arbitrarily  and  independently  of  exact  relation  to  the 
interest  rate.  Hence  a  constantly  changing  principal  is  involved  in  the 
figuring. 


4^2 


ACCOUNTS 


Let  C/=the  number  of  dollars  in  each  annuity  payment  (sometimes 
called  the  rent  of  the  annuity) 
AT = the  amount  (total  annuity  payments  plus  accumulations  of 
interest  on  payments  reinvested  or  available  for  reinvestment) 
of  a  specified  annuity  for  the  periods  specified 
«=the  amount  of  an  annuity  of  one  dollar  for  the  periods  specified 
An  annuity  will  accumulate  as  follows: 


Annuity 
received 

U 

U 

U 

U 


Interest  earned  by 
Prior  Annuities 


Total  received  Each 

Period 
U 

U^rU 

U+2rU+r^U 

U+srU+sr^U-i-r^U 


Amount 


U 

2U+rU 

SU+2rU+r*U 

4U+6rU+4r^U+rW 


rU 

3  u  2rU  +  rW 

4  U  zrU+zrW+rW 

This  process  might  be  continued  indefinitely,  but  no  formula  can  be 
constructed  from  it  alone  unless  we  know  the  number  of  periods.  We 
desire  a  formula  for  all  periods.^  If  we  now  take  another  annuity  that 
shall  give  for  a  part  of  its  history  a  table  corresponding  to  the  table  above, 
we  shall  be  able  by  comparing  the  two  tables  to  derive  a  general  formula. 
Let  us  take  an  annuity  of  U  +  rll,  that  is,  an  annuity  not  only  as  large  as 
the  first  but  larger  by  one  year's  interest  on  the  first.  For  this  annuity,  the 
table  for  four  years  is  as  follows : 


[S  Annuity 
P  received 


Interest  earned  by 
Prior  Annuities 


1  U+rU      

2  U+rU      rU+r^U 

3  U+rU    2rU  +  yW+rW 

4  U^-rU    srU+6rW-{-4r^U+r*U 


Total  received  Each 
Period 

U+rU 
U+2rU+r^U 
U+srU  +  sr^U+r^U 
U-\-4rU+6r^U-{- 

[4rW+r*U 


Amount 

U+rU 
2U+3rU-^rW 
SU+6rU  +  4rW-\-r^U 
4U+iorU+iorW-{- 
[Sr^U+r*U 


*  The  method  to  be  followed  is  so  complicated  that  the  reader  may  find  help  in  a 
sort  of  check -list  following  the  course  of  the  argument.  For  that  reason  an  abbre- 
viated outline  is  given  here,  in  order  that  as  the  reader  progresses  he  may  mentally 
check  up  his  advance. 

Am'tann.  ri7  =  am't  ann.  (C7-f  rt/)— am't  ann.  U 

=  last  income  ann.  (f/+rZ7)— first  income  ann.  U 

=  t^+rZ7  +  comp.  int.  on  (U+rU)  for  periods  {p—i)—U 

=  rZ7-f  comp.  int.  on  {U+rU)  for  periods  (^— i) 

=  comp.  int.  on  U  for  p  periods 

=  £/» 

Am't  ann.  U  =  — 


I 


APPENDIX    F  423 

Having  now  two  annuities  operating  on  the  same  basis,  we  can  deter- 
mine the  amount  of  an  annuity  equal  to  the  difiference  between  them  by 
subtracting  the  amount  of  one  from  that  of  the  other;  for  the  amount  of 
annuities  must  vary  exactly  as  the  amount  of  their  principals.  The  last 
sum  in  each  table  is  the  amount  of  the  annuity  specified.  If  the  larger 
of  these  is  subtracted  from  the  smaller,  the  difference  is  the  amount  of 
an  annuity  of  rU\  for  Amount  of  annuity  of  U  •\- rU  —  kmouni  of  annuity 
of  l^  =  Amount  of  annuity  of  rU.  Then  Amount  of  annuity  of  rU  =  ^rU 

It  happens,  moreover,  that  this  sum  just  obtained  is  exactly  the  dif- 
ference between  the  last  income  of  the  larger  annuity  and  the  first  income 
of  the  smaller,  or,  as  can  be  seen  from  the  table,  U  +  ^rlJ ■{■  6r'^U + 
/^r^U  +  r^U  —  U.  This  is  not  a  mere  coincidence.  A  little  analysis  shows 
it  to  be  inevitable,  however  many  the  periods.  We  chose  for  our  larger 
annuity  a  sum  larger  than  that  of  the  smaller  by  the  amount  of  a  year's 
interest.  So  the  first  income  of  the  larger  annuity  must  be  the  same  as 
the  second  income  of  the  smaller  —  for  the  smaller  will  receive  in  a  year 
what  the  larger  receives  at  the  start.  This  relation  must  continue  regu- 
larly between  the  two  tables;  for  the  larger  annuity  is  always  ahead  by 
the  amount  of  one  year's  accumulation  of  interest  on  the  smaller.  The 
amounts  of  the  two  annuities,  then,  will  correspond  except  to  the  extent 
of  the  first  income  of  the  smaller  (which  the  larger  never  gets)  and  the 
last  income  of  the  larger  (which  the  smaller  never  gets).  This  will  be 
true,  moreover,  for  any  number  of  periods;  for  since  all  items  in  the  tables 
except  the  first  and  the  last  cancel  each  other,  the  determining  element  is 
that  last  period,  however  long  or  short  the  series  may  be.  A  reference 
to  the  tables  will  make  this  clear. 

We  have  remaining,  then,  in  order  to  find  the  amount  of  an  annuity 
of  rU,  only  to  find  a  formula  for  the  last  income  of  U  +  rll.  Let  us  ana- 
lyze this  last  income.  It  consists  of  the  periodic  payment  of  the  annuity, 
or  rent,  plus  the  last  earning  of  interest  on  accumulations.  The  earning 
of  interest  on  accumulations  for  the  last  year,  however,  must  be  related 
to  compound  interest  on  the  annuity.  This  can  be  shown  by  a  brief 
analysis.  The  last  earning  of  interest  is  as  follows:  one  year's  interest 
on  the  last  annuity  payment,  one  year's  interest  on  the  previous  annu- 
ity payment  combined  with  the  accumulated  interest  of  the  year  be- 
fore, and  one  year's  interest  on  the  first  annuity  payment  combined  with 
the  accumulated  interest  of  two  years.   This,  however,  is  the  same  as 


424  ACCOUNTS 

compound  interest  for  three  years  —  or  for  one  period  less  than  the 
elapsed  time  of  the  annuity  —  on  one  annuity  payment.  A  table  will 
show  this.  Since  here  we  are  after  an  illustration  and  not  a  formula,  we 
may  well  use  figures,  assuming  an  annuity  of  $104,  at  4%,  for  four  years. 

Amount  of  an  annuity  of  $104,  for  four  years,  at  4% 


Year 

T 

Annuity        In 

$104 

104 

104 

104 

terest  Earning 

Total  to  add 

$104 
108.  16 
112.4864 
116.985856 

Amount 
$104 
212.16 
324.6464 

*. 

2 

3 
4 

$4.16 
8.4864 
12.985856 

Compound 

interest  on  $104, 

for  four  years,  at  4% 

Year 

I 
2 
3 

Amount  at  Begii 
ning  of  Year 
$104 
108.16 
112.4864 

Interest 

$4.16 
4.3264 
4.499456 

Amount  at  End 
of  Year 
$108.16 
112.4864 
116.985856 

Compounc 
Interest 

$4.16 
8.4864 

12.985856 

The  reason  for  carrying  the  figures  through  a  smaller  number  of  periods 
in  the  compound-interest  table  is,  of  course,  that  an  annuity  begins  to 
earn  interest  only  at  the  end  of  the  first  year;  for  nothing  is  due  until 
then,  and  then  only  the  first  annual  rent  is  received. 

We  have  found,  then,  an  easy  means  of  figuring  the  last  income  of  the 
larger  of  our  two  annuities,  that  is,  that  for  U  +  rll;  for  we  have  found 
it  to  be  the  rent,  or  U  +  rU,  plus  the  compound  interest  of  one  year's  rent 
for  periods  (/>—  i).  Let  us  summarize  our  process  up  to  this  point.  The 
amount  of  an  annuity  for  rU  is  the  last  income  of  an  annuity  of  U  +  rlJ 
minus  the  first  income  of  an  annuity  of  U.  The  former  of  these  we  have 
just  seen  to  be  U  +  rU  plus  the  compound  interest  of  U  +  rU  for  one 
period  less  than  the  time  involved;  and  the  latter  of  these  is  simply  U. 
This  may  be  expressed  as  follows:  Amount  of  annuity  of  rU=U  +  rU 
plus  compound  interest  of  U  +  rU  for  periods  (p—  i)  minus  U.  The  two 
U^s  cancel.  We  have  left  to  find  only  rU  plus  the  compound  interest  of 
U-\-rU  for  periods  (/>— i). 

It  happens  that  our  value  of  U  +  rU  is  purely  fictitious,  for  the  expres- 
sion has  no  part  in  our  real  problem :  our  task  is  to  find  the  amount  of 
an  annuity  of  U,  and  we  found  U  +  rU  only  as  a  step  on  the  way.  If,  then, 
we  can  find  a  constant  relation  between  the  compound  interest  of  U  +  rU 
and  that  of  U,  we  shall  have  our  formula  in  terms  of  given  values.  Such 
a  constant  relation  obviously  does  exist,  and  must  be  of  the  same  sort  as 


APPENDIX    F  425 

that  which  we  found  to  exist  between  the  amounts  of  their  annuities. 
JJ  +  rU  when  earning  compound  interest  starts  at  the  point  which  U 
attains  in  one  year,  and  its  amount  is  always  one  year  in  advance.  Since 
the  compound  interest  is  always  the  amount  minus  the  principal,  how- 
ever, the  interest  of  the  smaller  sum  will  in  four  periods  be  greater  than 
that  of  the  larger  sum  in  three  periods  by  the  difference  in  principals; 
for  from  the  amount  of  the  smaller  sum  for  four  periods  (which  is  the 
same  as  that  of  the  larger  sum  for  three  periods)  a  smaller  principal  is 
subtracted,  and  so  the  remainder  is  larger  by  that  amount.  A  table,  to 
be  compared  with  the  last  table  given,  illustrates  this  by  the  use  of  a 
principal  of  $100. 


ear 

Amount  at  Begin- 
ning of  Year 

Interest 

Amount  at  End 
of  Year 

Compound 
Interest 

I 
2 
3 

$100 
104 
108.16 

$4.00 
4.16 
4.3264 

$104.00 
108.16 
112.4864 

$4.00 
8.16 
12.4864 

4  112.4864  4.499456  116.985856  16.985856 

The  compound  interest  of  $100  is  for  any  period  more  than  that  of 
$104  for  the  preceding  period  by  just  the  amount  of  difference  in  principal 
between  them;  that  is,  $100  gives  for  four  periods  $16.98,  which  is  $4.00 
more  than  the  $12.98  given  by  $104  for  three  periods;  and  this  is  so  be- 
cause of  the  amount  of  $100  at  the  end  of  the  fourth  year  all  but  $100 
was  earned  as  interest,  whereas  of  the  amount  of  $104  at  the  end  of  three 
years  $104  must  be  subtracted  to  find  the  interest  Now  the  difference 
between  these  two  sums  of  compound  interest,  being  the  difference  in 
principal,  is  exactly  the  difference  between  U  and  U  +  rll.  We  found 
some  time  ago  that  we  could  use  the  compound  interest  for  U  +  rU  in 
determining  the  amount  of  an  annuity  of  r^,  and  hence  of  U.  It  would 
now  be  far  more  to  our  purpose  if  we  could  use  the  compound  interest 
of  U,  however,  for  our  problem  is  concerned  with  U.  We  were  going  to 
use  the  compound  interest  of  U-trU  for  periods  (p—  i)  plus  rU.  Now 
we  find  that  the  compound  interest  of  U  for  p  periods  is  exactly  the  same 
as  that  oi  U  +  rll  for  periods  (/>—  i)  plus  rU.  Here,  then,  is  exactly  what 
we  want. 

The  amount  of  annuity  of  rU=  compound  interest  of  U  for  p  periods. 
Since  both  amounts  and  interest  vary  directly  as  the  principals  concerned, 
our  equation  can  be  expressed  as  follows: 


426    -  ACCOUNTS 

.           ^    .          .^     e  TT      compound  interest  of  U  for  p  periods 
Amount  of  annuity  of  £/  = ^-^ 

Fonnula  VI.  N  =  — -  or  — i— '-  or 


r  r  r 

i       fl^-i 

n  =  —  or 

r  r 

This  very  long  and  elaborate  working  out  of  the  problem  may  be  very 
briefly  stated  in  algebraic  form  as  follows : 

hmo\iViioidJmmiy oiU==U-\-Ua-\-Ua^+Ua^+Ua^-\-  .  .  .  ^-UaP-' 
Amount  of  annuity  of  f/a  =  C/a  +  Z7a2  +  C^flHC/aHt/'a''+  ...  -\-Ua?' 
Amount  of  annuity  of  {Ua-U)  =  Ua^  -  U 
Amount  of  annuity  of  U{a-i)  =  Ua^-U 

Amount  of  annuity  of  Z7  = 

a-i 


To  find  the  present  worth  of  an  annuity 

This  problem  may  be  worked  out  on  the  same  basis  as  the  last.  Since 
the  principle  is  the  same,  only  substituting  present  worth  for  amount  and 
discount  for  interest,  we  do  not  need  to  analyze  it  in  detail. 

Briefly,  the  present  worth  of  an  annuity  of  U  for  any  number  of  periods 
is  made  up  of  the  present  worth  of  each  of  the  annual  installments  of  Z7, 
and  the  present  worth  of  an  annuity  of  U-\-rU  is  the  present  worth  of 
the  annual  installments  of  U+rll;  and  the  present  worth  of  an  annuity 
of  rU  is  the  difference  between  the  present  worths  just  mentioned,  — 
or  the  present  worth  of  the  first  income  of  the  large  annuity  minus  the 
present  worth  of  the  last  income  of  the  small  annuity.  This  last  differ- 
ence, by  Formula  V,  is  the  same  as  the  compound  discount  on  U  for  p 
periods. 

Let  m  =  the  present  worth  of  an  annuity  of  one  dollar 
M  =  the  present  worth  of  an  annuity  of  a  specified  sum 
The  present  worth  of  an  annuity  of  rU^  then,  may  be  expressed  as  follows: 

rUm=-Ud 

r 


APPENDIX 

F 

i-i- 

VII. 

m  = 

d 

—  or 
r 

a' 

r 

M  = 

Si.„-£ 

427 


The  actual  method  of  deriving  this  is,  without  explanation,  as  follows: 
Present  worth  of  annuity  of  Z7= — \-—+—-\-  —  +  .  .  .  -f — 

Present  worth  of  annuity  of  C/fl  = H— r  +  -T"i — r+   •  •  •  +-^0^ 

a       a^       a^       a*  a" 


a     a^    a^    a*  a^~^ 


Present  worth  of  annuity  of  Ua-U  =  U 


a' 


but,  by  supposition,  Ua  —  U=rU 

U 
Present  worth  of  annuity  of        fU=U——^ 


a' 


U-^     Uii-^) 


M= or 


but  i--=J 
a' 


This  may  be  derived  in  still  another  simple  way.  The  amount  of  an 
annuity  we  have  already  found  by  Formula  VI  to  be  — ^ •     The 

present  worth  of  the  annuity  is  the  present  worth  of  the  amount  of  the  an- 

p 
nuity.  Formula  III  gives  us  W=  —  In  the  case  before  us,  P  is  the  amount 

of  the  annuity,  or  —^ — ^'  Then  ^  is  the  present  worth 

of  the  annuity.  Then 

Jlf= — f 


428  ACCOUNTS 

To  find  what  annuity ^  or  sinking  fund,  will  amount  to  a  given  sum 
This  merely  reverses  the  problem  of  Formula  VI.  If  an  annuity  of  one 

dollar  will  amount  to  n,  the  desired  number  of  dollars  divided  by  n  will 

show  the  number  of  dollars  in  the  annuity  desired. 

N               N  Nr 

Formula  VIII.    U  =-  or  il or  -lll- 


To  find  what  investment  will  buy  a  given  annuity 

This  is  simply  the  problem  of  the  present  worth  of  an  annuity.  Since, 

by  Formula  VII,  M=  — ,  and  M  is  in  this  problem  the  principal  to  be 
determined,  we  substitute  P  for  M  and  get 


Formula  IX.  P  =  — or 


"(-i) 


To  find  what  annuity  a  given  sum  will  buy 

This,  too,  is  a  problem  in  the  present  worth  of  an  annuity.  Here  our 
given  sum,  or  P,  is  the  same  as  the  present  worth,  or  M  of  Formula  VII. 
If  the  present  worth  of  an  annuity  of  one  dollar  is  w,  the  present  worth  of 
the  unknown  sum  will  be  P  divided  by  m. 

Formula  X.  U  =  -  or  — ? —  or  ^  or     ^^ 


To  find  the  yield  of  a  bond  purchased  at  a  given  price 

As  was  stated  in  Chapter  XII,  no  method  has  been  discovered  for  find- 
ing in  all  cases  the  exact  yield  of  a  bond  by  figuring  backward  from  the 
known  price  —  unless  a  rate  of  interest  on  assumed  reinvestments  is  to  be 
taken  for  granted.  To  assume  a  rate  on  reinvestments  different  from  that 
on  the  principal  is  obviously  to  put  aside  the  thing  one  is  trying  to  learn. 
By  such  a  process  a  part  of  the  yield  of  the  investment  is  made  to  depend 
on  the  rate  arbitrarily  chosen  for  reinvestments.  Even  when  this  method 
is  used  for  purposes  of  comparison  it  is  misleading  if  the  ratios  of  reinvest- 
ment to  principal  are  different  in  the  two  cases.  What  an  investor  really 
wishes  to  know  is  usually  the  rate  paid  on  investments  of  this  class;  and 
that  assumes  returned  premium  to  be  either  reinvested  in  securities  of  the 
same  class  or  else  not  reinvested  at  all.  The  only  method  of  determining 


APPENDIX   F  429 

this  is  approximation,  as  described  in  Chapter  XII.   When  one  assumes 
a  different  rate  for  reinvestments,  however,  a  formula  may  be  derived  by 
algebra  with  the  aid  of  logarithms  to  determine  the  average  yield  —  not 
the  yield  of  the  original  investment.  This  method  compares  the  purchase 
money,  or  cost,  with  what  it  will  amount  to  at  the  end  of  the  time,  and  so 
determines  the  rate  of  increase. 
Let  y=th.e  rate  paid  nominally  by  the  bond 
r=the  rate  assumed  for  reinvestments 
3c=the  rate  to  be  found 
W^= present  worth,  or  cost,  of  the  bond 
P=the  face  of  the  bond 
The  amount  of  the  bond  at  maturity  will  be  made  up  of  the  face  value, 
or  P,  plus  the  amount  of  the  interest  (an  annuity  for  yP  compounded  at  the 
rate  r).    We  may  now  apply  Formula  I  —  in  which  P  becomes  for  this 
problem  W  and  a  becomes  i  +x,  —  and  Formula  VI  —  in  which  U  be- 
comes yP,   We  get,  then, 

r 

That  is  to  say,  the  present  worth  of  the  bond  at  compound  interest  equals 
the  face  value  plus  the  amount  of  the  annual  interest  payment  that  it  pro- 
vides (the  amount  of  an  annuity).   Then 

W  rW 


l+X: 


(P      yPa^-ypVp 


^^^Pr+yPaP-yPl3     ^ 


\  rW 


Such  an  equation  can  be  resolved  only  by  means  of  logarithms,  of  course. 
For  illustration,  if  y  =  -04,  ^=.035,  P=ioo,  ^^  =  114,  and  ^  =  26,  the 
formula  would  be  applied  as  follows: 


^     I        .035X114        j 


430  ACCOUNTS 

By  logarithms:  log.  i.o35^=log.  1.035X26=0.01494X26=0.38844= 
log.  2.4459- 
2.4459 X4-.S=9-2836;   .035X114=3-99;  9-2836-^3.99  =  2.3262. 
log.  2.3262^5  =log.  2. 3 262 -J- 26 =0.36665-^26 =0.01410= log.  1.0330. 
1.033 -I  =  .033,  ^^^  desired  rate. 

To  find  for  depreciation  a  steady  percentage  on  last  valuation  that  will 
redtice  to  a  fixed  scrap  value 

Let  P=the  cost 

5= the  scrap  value 

x=i\iQ  rate  of  depreciation 

2£;=the  percentage  which  each  new  valuation  bears  to  the  last, — 

that  is,  iQo%-x 
^  =  the  number  of  years 

The  series  of  valuations  will  then  run  as  follows :  P,  Pw,  Pw^,  Pw^j  etc., 
for  as  many  periods  as  the  years  indicated.  The  last,  or  scrap  value,  then, 
will  be  Pw^, 

Then   S^Pw'>;   |=^;  (1)^=^;   (|)^=icx)-a;;  a;=ioo-(D^. 

Since  S  and  P  are  given,  the  root  may  be  extracted  by  logarithms. 
Formula  XI.  ;c=100-^|y- 

To  apply  this  to  the  problem  on  page  320 
5=20,  P—200,  P=S' 

J 1 20 

jX;  =  ioo— V 

^200 

20  _ 
200 

log.  of  .1  =  1.00000 
-7-5  =  1.80000 

natural  number  corresponding       =.63095,  or  63.095% 
100-63.095=36.905 
The  desired  percentage,  then,  is  36.905. 


APPENDIX  F  431 

To  find  a  hank  reserve 

As  previously  indicated,  banking  prior  to  the  inauguration  of  the 
Federal  Reserve  Sytem  involved  some  accounting  considerations  more 
interesting  than  those  of  the  new  system.  The  difficulties  in  the  way  of 
figuring  the  amount  of  reserves  have  already  been  suggested  in  Chap- 
ter XVI.  One  method  of  doing  the  work  is  described  below. 

Since  the  amount  not  only  of  absolute  reserve  but  also  of  proportion  of 
cash  reserve  differs  with  the  class  of  city  in  which  a  bank  is  located,  two 
forms  are  necessary  to  cover  the  field.  As  far  as  that  is  possible  we  shall 
use  the  same  figures  for  both  conditions,  so  that  the  differences  shall  be 
evident. 

We  may  well  begin  both  statements  with  the  report  of  the  relation  of  the 
bank  in  question  with  other  banks  not  reserve  agents,  for  in  some  condi- 
tions, as  previously  explained,  this  affects  the  amount  of  deposits  to  be 
covered  by  reserve.  Next  we  may  deduct  from  the  liability  for  reserve  all 
direct  sums  allowed  to  be  deducted  from  the  deposits  before  the  liability 
for  reserve  is  calculated,  such  as  clearing-house  items,  redemption  fund, 
etc.  Then  we  shall  be  ready  to  apply  our  formulae  for  determining  what 
reserve  is  required. 

These  formulae  are  derived  on  the  following  plan.  Since  in  banks  not  in 
reserve  cities  the  reserve  must  be  fifteen  per  cent,  of  the  amount  of  de- 
posits, of  which  three-fifths  may  be  on  deposit  with  reserve  agents,  the 
requirement  for  reserve  is  met  if  the  lawful  cash  is  six  per  cent.,  and  the 
deposits  with  reserve  agents  are  nine  per  cent.  The  problem,  as  explained 
in  Chapter  XVI,  is  to  know  how  much  of  the  excess  deposits  with  reserve 
agents,  if  any,  may  be  counted  to  reduce  liability  for  reserve  in  the  matter 
of  sums  due  to  other  banks.  To  express  this  in  another  way:  the  reser\'e 
with  reserve  agents,  less  any  excess  over  the  countable  9%,  must  be  9%  of 
the  total  deposits  less  such  excess ;  for  the  excess  reduces  the  amount  upon 
which  the  9%  is  taken;  but  the  excess  does  not  reduce  deposits  to  be 
covered  except  as  it  can  reduce  sums  due  to  banks. 

Let  fl= gross  deposits 

6= sums  with  reserve  agents 

«  =  amount  with  reserve  agents  in  excess  of  the  amount  allowed  to 
count  on  the  9%  basis  (but  countable  at  100%  against  deposits 
by  banks  only)  or  on  the  12^%  basis. 


432  ACCOUNTS 

Then  b-x=~{a-x) 

lOO 

I00&  —  ioo5;;=9a -9^ 
ioo6-9a=9i:v 

100b -ga 


x= 


91 


For  banks  in  reserve  cities,  on  the  other  hand,  since  the  total  reserve 
must  be  25%  and  cash  must  be  one-half,  our  proportion  of  reserve  count- 
able on  the  widest  basis  is  i2i%  or  J.  Our  equation  then  becomes 

,  a  —  x 

b  —  x= 

8 

Sb  —  Sx  =  a  —  x 

Sb  —  a  =  'jx 

Sb  —  a 
x= 


Now  we  are  ready  to  apply  these  to  some  practical  conditions.  Sup- 
pose our  balance  sheet  shows  the  following  items:  due  to  banks,  $235,- 
000;  due  from  banks  not  reserve  agents,  $212,000;  clearing-house  items, 
$186,000;  national  bank  notes,  $19,000;  redemption  fund,  $3000; 
deposits,  $2,392,000;  due  from  reserve  agents,  $285,000;  lawful  cash, 
$294,000. 

For  a  bank  not  in  a  reserve  city  the  statement  would  work  out  as 

on  page  433. » 

1  It  should  be  explained  that  in  certain  conditions,  met  in  one  of  the  cases  worked 
out  for  these  figures,  the  application  of  this  rule  gives  a  slight  exaggeration  of  the 
excess  with  reserve  agents  actually  unavailable;  but  this  exaggeration  is  of  no  con- 
sequence, for  no  use  can  be  made  of  it.  The  amount  of  excess  with  reserve  agents 
is  learned  in  order  to  see  how  much  may  be  applied  against  sums  due  to  other  banks; 
and  when  any  excess  is  so  applicable,  every  $91  of  the  excess  covers -$100  of  deposits; 
for  every  $100  applied  to  offset  sums  due  to  other  banks  reduces  by  $100  the  de- 
posits to  cover,  and  every  $100  of  such  reduction  releases  a  new  $9  of  reserve-agent 
funds  —  in  effect,  then,  $91  reduces  $100.  ^nce,  however,  unavailable  excesses  are 
not  applied  at  all,  they  do  not  release  a  further  9%  of  themselves,  and  so  the  formula 
gives  for  unavailable  excesses  an  exaggerated  figure,  or  100/91  of  the  actual  unavail- 
able excess.  When,  however,  the  excess  is  available  to  offset  sums  due  to  banks  (the 
only  condition  of  consequence),  no  exaggeration  occurs. 


APPENDIX    F 

433 

Calculation  of  Reserve  for  a  Bank  not  in  a  Reserve  City 

Schedule  A 

Schedule  B 

Due  to  banks 

$235,000 

Clearing-house  items,  etc. 

$186,000 

Due  from  banks  not  reserve 

National  bank  notes 

19,000 

agents 

212,000 

Redemption     fund     multi- 

Bank deposits  to  cover 

23,000 

plied  by  6§ 

20,000 

Individual  deposits,  etc. 

2,392,000 

Deductions 

225,000 

2,415,000 

Deductions  (Schedule  B) 

225,000 

Schedule  C  {applying  forn 
Due  from  reserve  agents 

multiplied  by  100 
Gross    deposits    multiplied 

ula) 

Gross  deposits  to  cover 

2,190,000 
23,000 

285,000 

Available  excess  (Schedule  C) 

28,500,000 

Net  deposits, 

2,167,000 

15%         = 

325.050 

by  9 

19,710,000 

§  (6% cash  required) = 

130,020 

8,790,000 

Lawful  cash  on  hand 

294,000 

divided  by  91  =  (excess)       96,593 

Cash  excess 

163,980 

Excess  available  to  offset 

deposits  from  banks 

23,000 

Unavailable  excess  with  re- 
serve agents 

73.593 

If  the  accounts  with  banks  not  reserve  agents  had  showed  a  balance 
on  the  other  side,  the  amount  would  have  been  disregarded  altogether; 
for  it  would  have  represented  neither  a  deposit  with  the  bank  nor  a  sum 
available  as  reserve  to  cover  deposits.  If,  on  the  other  hand,  it  had  been 
on  the  same  side  as  now  but  larger  in  amount,  more  of  the  excess  with 
reserve  agents  would  have  counted  and  thus  have  reduced  the  require- 
ment of  cash ;  for  since  under  these  conditions  the  sum  due  to  other  banks 
was  only  $23,000,  only  $23,000  of  the  $96,593  of  excess  with  reserve  agents 
was  allowed  to  count  at  all. 

It  will  be  noted  that  the  custom  of  applying  the  redemption  fund  to 
deposits  before  the  reserve  is  figured  distinguishes  between  this  fund 
and  the  other  lawful  money  counted  against  deposits.  The  other  law^ 
ful  money  covers  on  the  6%  basis,  for  9%  may  be  covered  by  deposits 
with  reserve  agents.  The  redemption  fund,  on  the  other  hand,  covers 
only  on  a  15%  basis,  for  no  deposits  with  reserve  agents  are  included  in 
the  reserve  for  the  amounts  so  covered.  Thus  this  method  provides  an 
actually  greater  cash  reserve  than  would  be  provided  if  the  redemption 
fund  were  counted  with  the  other  lawful  money. 

Now  let  us  apply  the  same  figures  to  a  bank  in  a  reser\'e  city. 


434 

ACCOUNTS 

Calculation  o 

/  Reserve  jor  a  Bank  in  a  Reserve  City 

Schedule  A 

Schedule  B 

Due  to  banks 

$235,000 

Clearing-house  items,  etc. 

$186,000 

Due  from  banks  not  reserve 

National  bank  notes 

19,000 

agents 

212,000 

Redemption     fund     multi- 

Bank deposits  to  cover 

23,000 
2,392,000 

plied  by  4 
Deductions 

12,000 

Individual  deposits,  etc. 

217,000 

2,415,000 

Deductions  (Schedule  B) 

217,000 

Schedule  C  (applying  fon 

Gross  deposits  to  cover 

2,198,000 

nula) 

Available  excess  (Schedule  C) 

11,714 

Due  from  reserve  agents 

285,000 

Net  deposits 

2,186,286 

multiplied  by  8 

2,280,000 

25%        = 

546,571 
273,286 

Gross  deposits 

2,198,000 

\  (i2j% cash  required) 

82,000 

Lawful  cash  on  hand 

294,000 

divided  by  7  =  (excess) 

11,714 

Cash  excess 

20,714 

Excess  available  to  offset 

deposits  from  banks 

11,714 

Unavailable  excess  with  re- 
serve agents 

0,000 

It  is  common  to  enter  deficiency  as  well  as  excess  in  the  statement  of 
relations  with  reserve  agents.  This,  of  course,  is  not  a  real  deficiency; 
for  the  law  does  not  require  a  bank  to  keep  any  of  its  reserve  on  deposit 
with  reserve  agents.  So  the  term  deficiency  in  that  use  is  only  a  convenient 
designation  for  a  figure  of  no  real  consequence.  Such  deficiency  is 
always  to  be  offset,  of  course,  by  a  cash  excess;  but  a  cash  deficiency 
cannot  be  offset  by  any  bank  excess. 

Deficiencies  actual  as  well  as  nominal  are  not  uncommon  in  time  of 
financial  pressure.  The  Comptroller  may,  after  due  warning,  close  a  bank 
failing  to  maintain  the  required  reserve,  but  he  does  so  only  when  the 
condition  is  evidence  of  permanent  distress.  To  close  all  banks  showing 
deficiency  in  times  of  tight  money  would  precipitate  a  widespread  and 
disastrous  panic. 

Figuring  the  reserve  by  the  formulae  given  above  becomes  necessary 
only  when  the  limit  is  approaching.  In  both  cases  given  in  detail  above 
a  glance  makes  it  evident  that  the  cash  reserve  is  so  much  in  excess  of  the 
required  6%  or  i2j%  that  the  sums  with  reserve  agents  are  ample  to 
cover  the  remainder  of  the  requirement. 


INDEX 


INDEX 


[In  view  of  the  arrangement  of  this  book,  as  indicated  on  page  vii,  the  index  is  especially  full. 
On  many  of  the  pages  cited  one  may  not  find  any  use  of  the  words  used  as  titles  in  the  index. 
In  such  cases,  the  passages  discuss  the  thing  indicated  in  the  index,  though  by  another  name, 
or  they  give  illustrations  of  the  thing  without  calling  it  by  name.  Under  Diference  of  interest, 
for  example,  page  i68  is  cited;  but  on  that  page  the  expression  does  not  occur,  though  the 
premium  on  the  bond,  by  the  second  method,  is  found  as  the  present  worth  of  the  difference 
between  the  bond  rate  and  the  market  rate;  but  the  exact  words  of  the  title  are  used  in  the 
second  reference,  page  177.  Under  Sinking  funds  for  retirement  of  bond  premium  is  a  reference 
to  page  178;  but  on  that  page  is  no  mention  of  such  a  fund.  The  first  few  lines  of  that  page, 
however,  describe  for  retiring  such  premium  a  method  which  is  in  effect  a  sinking-fund  method 
and  would  be  recognized  as  such  by  any  one  conversant  with  sinking  funds.  In  other  words, 
the  index  cannot  be  a  short-cut  to  the  book  for  those  who  are  not  familiar  with  the  subject; 
but  it  points  the  way  to  elementary  things  as  well  as  to  the  more  complex.] 


Account  —  allowance,  102-107,  113-114, 
116,  124,  210,  220 

clearing,  314,  408 

closing  an,  45-54,  407-409 

controlling,  68,  260,  380,  385 

defined,  18 

external,  21 

force,  II,  12 

group,  314 

impersonal,  22 

intermediate,  314 

internal,  21 

nominal,  29,  44,  83-92 

personal,  22 

petty,  415 

primary,  314 

property,  ii 

proprietorship,  55,  56 

real,  29,  44,  83-92 

reserve,  loi,  102,  111-114, 125,  220 

title  for,  21 

ultimate,  314 

(see  also  special  accounts) 
Accountability  distinguished  from  liabil- 
ity, 13  ,  ^     ^ 
Accountancy  —  moral  aspect  of,  364 

profession  of,  365 
Accounting  defined,  4,  83 
Accounts    payable  —  register    for,    376, 

397 

use  of,  67,  79 
Accounts  receivable  —  interpreted,  116 

register  for,  378,  397 

use  of,  67-69,  79 
Account  sales,  380 
Accrued  interest  account,  45  n,  192-194 


Accrued  items  —  allowances  for,  40-42, 
48-49,  54,  407-409 

on  balance  sheet,  223 

expense,  54 

interest,  42,  43,  45  n,  54,  192-194 

rent,  54  ^ 
Accumulation  on  bonds  —  account,  194- 
195,  261 

defined,  170 

tables  constructed,  1 71-172 
Actuaries,  263 
Additional  rates,  288,  289,  291,  295,  296, 

312 
Adjustment  account,  359 

(see  also  Settlement  account) 
Adjustment  bonds,  244 
Adjustments  in  factory  estimates,  294 
Administration  costs  —  in  factories,  294, 
297,  311  ^ 

(see  also  Municipal  accounting) 
Administratorship,  352 
Advances  to  branches,  126,  236 
Advertising,  289, 302, 312 
Algebraic  expressions  summarized,  419 
Allowance  accounts,    102-107,   113-114, 

116,  124,  210,  220 
Amortisation  —  account,   193-T94,   196- 
198 

defined,  170 

sinking  fund  for,  178,  185-190 

tables  constructed  for,  170-185 
Amount  —  of  annuity  (formula),  421 

of  principal,  160,  (formula)  419 
Annuity  —  amount  of  (formula),  421 

cost  of  (formula),  428 

death-claim,  269 


438  ACCOUNTS 


defined,  i66 

by  life  companies,  263,  269 

present  worth  of,  166,  (formula)  426 

purchasable  forgiven  sum  (formula) ,  428 

required  to  attain  given  sum  (formula), 
428 
Appreciation,  95,  173 
Appropriations,  334 
Armories,  331 
Art,  332 
Assets  —  available,  222,  333 

capital,  221 

contingent,  224,  333 

current,  138,  222 

pledged,  354-358 

quick,  138 

statement  of,  40-43,  52,  84,  137,  354- 
358 

wasting,  96 

(see  also  Resources) 
Atchison,  Topeka  &  S.F.R.R.  —  analysis 
of  operations    and    condition,    230- 

reorganization  of,  243-248 
Atlantic  &  Pacific  R.R.,  235,  236 
Auditing,  329,  363-365 
Auxiliary  books,  396-400 

Bad   debts  —  losses   by,    115-117,    138, 
224  n 

allowance  for,  116,  138 
Balance  sheet  —  banking,  249-251 

comparative  shown,  no 

described,  52-54 

elucidated,  83-92,  221-225 

form  of,  52,  no,  225 

indicating  value,  52,  209,  346 

insurance,  268-269 

interpreted,  127-140 

municipal,  333 

purpose  of,  209 

railroad,  221-225 

trust,  259 
Balancing,  see  Closing  books 
Bank  discount,  25  n,  28,  163 
Bank  notes  —  redemption  fund  for,   250, 

251 

as  reserve,  251 
Bankruptcy  —  accounting  for,  354-362 

with  excess  assets,  138 
Banks  —  accounting  for,  249-254 

bookkeeping  for,  384-393 

capital  of,  250 

examination  of,  253 

surplus  in,  250 
Basis  rate  for  bonds,  183 
Baths,  332,  333 

Bills  discoimted  —  account,     122,     249, 
387-392 


liability  on,  121-122 

valuation  of,  121,  253 
Bills  payable  account,  24,  33 
Bills  protested,  1 21-12  2 
Bills  receivable  —  accoimt  —  interpreta- 
tion of,  115,  117 
use  of,  23,  33 

liability  on  endorsed,  121-122 
Bond  discount  as  asset,  199 
Bond  premium  as  liability,  199 
Bond  price  residues,  184,  196-197 
Bonds  —  accounts  for  issuer  of,  198-200 

accumulation  on,  170-190,  193-200 

amortisation  on,  170-190,  193-200 

basis  rate  on,  183 

book  value  of,  170 

income  of,  for  life-man,  185-190 

ledger  for,  192,  258 

optional-redemption,  200-202 

principal  classes  of,  200,  202,  241-242 

quotations  for,  195 

sales  of,  197,  259 

serial,  200 

tables  for,  178,  191  n 

with  two  rates  of  interest,  202 

valuation  of,  167-169 

yield  of,  184,  (formula)  428 
Book  accounts,  117 
Book  value  —  defined,  for  bonds,  170 

tables  of,  for  bonds,  170-183 
Bookkeeping  principles,  5n,  55,  58 
Books  —  auxiliary,  396-400 

bill,  396 

cost,  274 

principal,  396 

voucher,  416-417 

wages,  274 

(see  also  Cash;    Day;    Invoice;    Pur- 
chase; Sales) 
Branches  —  accounts  of,  126 

advances  to,  126,  236 

assets  in,  126 

merchandise  of,  126 
Bridges,  332 
Buildings  —  depreciation  of,  309,  318 

inspection  of,  331 

remodeling  of,  85-87 

repairs  of,  290,  309 
Burden  —  adjustments  of,  294,  312 

defined,  270 

distribution  of,  275-305 

period  for  distribution  of,  290 
By-products,  141-142 

Cambridge,  Mass.,  333 

Capital  —  charging  to,  defined,  85 

nature  of,  83-92,  203-220 

working,  222 
Capital  assets,  221 


V 


INDEX 


439 


Capital  deficit,  17.^,  403 
Capital  gain,  90,  262 
Capital  liabilities,  221 
Capital  loss,  90,  174-175,  402-403 
Capital   stock  —  account,  50,  120,  401- 
407 

apportionment  of ,  346-351 

authorized,  120 

subscribed,  401 

unissued,  120 

(see  also  Stock) 
Capital  surplus,  123,  175,  402 
Capitalization  —  bases  of,  203-215 

entries  for,  401-407 

meaning  of,  211 

principle  of,  203-220 
Car  statistics,  152,  153-155 
Car-trust  bonds,  242 
Cartage,  as  burden,  297,  308 
Cash  account  —  interpretation  of,  118 

petty,  415-416 

posting  to,  61 

use  of,  12,  22 
Cash  book  —  bank,  387 

columnar,  62-63,  74,  75.  3^2,  383 

commission,  382,  383 

defined,  17 

form  affecting  value  as  evidence,  71 

petty,  415-416 

special  column,  62-63,  74,  75,  382,  383 

use  of,  60,  65 
Cash  items,  118,  239 
Cash  sales,  66,  74,  76,  77 
Cash  variations,  14 
Celebrations,  332 
Cemeteries,  331,  333 
Certificates  of  deposit,  391  n 
Charities,  332 

Checking,  20,  39,  59,  63,  66' 
Checks  —  bank  holdings  of,  250 

as  cash,  22 

cashier's,  391  n 

certified,  391  n 

voucher,  417 
Clearing  accounts,  314,  408 
Clearing-house  items,  250,  252 
Closing  books,  45-54,  61,  407-409 
Collateral  index,  258 
Collateral  register,  258 
Collateral-trust  bonds,  242 
Collection  account,  388,  390-392 
Collection  register,  392 
Colorado  Midland  R.R.,  234,  235 
Columnar  books,  see  Cash  book.  Journal 
Columns  —  debit  and  credit,  18,  19 

special,  principle  of,  58,  62,  66 
Commercial  and  Financial  Chronicle,  238 
Commission  —  account,  261,  369,  380 

business  of,  accounting  for,  380-384 


Common  sense  as  accounting  principle ,307 
Comparative  cost  register,  275 
Comptroller  —  administrative,  363 

of  the  currency,  251 
Conducting  transportation  accounts,  143 
Consignments  account,  380 
Consolidations,  bases  for,  346-351 
Construction  account,  principle  of  charg- 
ing to,  203-218 
Contingent  assets,  224,  333 
Contingent  liabilities,  121,  224,  333 
Contracts  —  as  liability,  122 

profit  on  unfinished,  307 
Controller,  see  Comptroller 
Controlling  accounts,  68,  260,  380,  385 
Copyrights,  191 
Corporation  accounts,  401-407 
Corpus  of  estate,  352 
Correction  (department  of),  331 
Cost  —  analyses  of,  298,  299,  414 

capitalization  on,  203-220 

comparative,  register  for,  275 

defined,  208 

direct,  defined,  145,  270 

indirect,  illustrated,  145 

joint,  illustrated,  141,  270 

prime,  270 

secondary,  298 

(see  also  Burden) 
Cost  accounting  —  accuracy  of,  296,  299 

details  of,  270-326 

principles  of,  141-150 

purposes  of,  283 
Cost  of  annuity  (formula),  428 
Cost  book,  274 
Cost-of-road  account,  see  Construction 

account 
Courts,  331 
Cranes,  299 
Credit  —  defined,  9 

when  given,  10 
Credit  records,  378 
Currency,  comptroller  of,  251 
Current  assets,  138,  222 
Current  liabilities,  138,  222 

Dating  ahead,  378,  379 
Day  book  —  bank,  387 

combined  with  journal,  57,  58 

old-fashioned  —  described,  15-17 
illustrated,  16,  32 
use  of,  15,  69 
Debentures,  242 
Debit  —  defined,  9 

when  given,  10 
Deficiency  —  account,  360 

contrasted  with  deficit,  360 

statement  of,  361 

on  statement  of  affairs,  358 


440 


ACCOUNTS 


Deficit  —  bookkeeping  for,  51 

capital,  175,  403 

contrasted  with  deficiency,  360 
Department  expenses,  298 
Department-store  accounts,  393 
Deposits  —  account,  251,  385-393 

ledger  for,  384-390 

as  reserve,  250,  251 

reserve  for,  249-252 
Depreciation  —  account,  97,    loi,    105, 
321,  409 

allowance  for,  99-107,   109-116,   124, 
210,  220 

of  buildings,  309,  318 

defined,  103 

in  factories,  279,  282,  309,  317-322 

funds  offsetting  —  how  invested,   139 
source  of,  96-104,  111-114 

inevitable,  89 

general  treatment  of,  96-108,  111-116 

of  machinery,  279,  282,  309,  317-322 

mathematics  of,  320,  320  n,  (formula) 

430 
of  merchandise,  107,  120 
in  rate  making,  218-220 
reserve  for,  loi,  102,  111-114 
temporary  account  for,  105-107 
three  policies  of,  95 

"Difference  of  interest,"  168,  177 

Direct  expenses,  denned,  145 

Discount  —  account,    in    banking,    388, 
390-392 
bank,  25  n,  28,  163 
on  bonds,  172 

cash,  25,  70,  340-342,  369-374 
collected,  342,  372 

commercial,  25,  70,  340-342,  369-374 
compound,  163,  (formula)  421 
distinguished  from  interest,  25 
merchandise,  25,  70,  340-342,  369-374 
method  of  entry  for,  26-28,  70,  369, 

371-374,  382-384 

neglected,  342,  372 

register  for,  banking,  387-392 

on  stock,  403-405 

true,  163 
Discounted  notes  —  as  contingent  liabili- 
ties, I 21-12 2 

entries  for,  32,  33,  34,  122,  387-392 
Disposition  of  income  account,  93 
Distribution,  in  insurance,  268 
Divided  entries,  62,  65,  66,  70,  74n,  75 n, 

76n,  77n 
Dividends  —  account,  51 

from  capital,  96,  219 

compared  with  capital,  212-218 

scrip,  140 

stock,  140,  213-217,  352 

when  defensible,  139 


Docks,  332 
Donated  surplus,  404 
Donations  of  stock,  403-405 
Double  entry  —  defined,  13-14 

labor  of,  66,  369 
Dowers,  191,  269 
Drafts,  recorded  how,  10,  22,  23 
Drawings  —  in  manufacturing,  299 

partners',  352-354 
Duplication,  cost  of,  capitalization  oD; 
203-208 

Earning    capacity  —  capitalization    on, 
203-218,  346-351 

indicating  goodwill,  346-351,  405-407 
Earnings  —  gross,  defined,  226 

net,  defined,  226 

(see  also  Income;  Revenue) 
Eaton,  J.  Shirley,  149 
Economies  as  aim  of  accounting,  283 

(see  also  Waste) 
Education,  332 
Electric  light  plants,  332 
Embezzlement,  253 
Endorsed  notes  as  contingent  liabilities, 

121-122 
Equipment  account,  222,  272 
Erasures,  avoided,  16 
Errors  corrected,  16 

(see  also  Trial  balance) 
Estate  accounting,  352 
Estimated  output  as  a  factor  in  burden 

distribution,  284,  290-294 
Estimates  of  cost,  correction  of,  294 
Estimating,  cost  of,  301,  312 
Evidence,  see  Legal  evidence 
Excess  deposits,  252 
Executorship,  352 
Expectation  of  life,  263 
Expenditures  —  analysis  of,  127-132 

classification  of  municipal,  330-333 
Expense  —  account,  28 

as  burden,  311 

inventory  of,  54 

municipal,  331 

operating,  defined,  226 

statement  of,  40,  43,  53,  92,  94,  227- 
229,  325 

(see  also  Burden;  Costs) 
Expenses  of  liquidation  account,  358, 3591 

360 
External  accounts,  defined,  21 

Factory  accounting,  270-326 

Federal  reserve  system,  254  n 

Fire  Department  costs,  328,  331 

Five  elements,  278,  279,  280,  297,  299, 

301 
Fixed  charges,  defined,  145,  226 


INDEX 


441 


Flasks,  299 

Force  accounts,  11,  12 

Formulae,  419-434 

(see  also  special  subjects) 
Fortuitous  element  of  profits,  344 
Franchises,  as  property,  191,  222,  247 
Freight  —  as  burden,  297,  308 

statistics  of,  i54-i55>  231-233 
Fuel,  294,  309,  317 
Funded  debt  —  described,  221 

sinking  fund  for,  123-126,  336-339 
Funds  (special)  —  as  assets,  96-104,  iio- 
115,  123-126,  225,  330,  338 

offsetting   depreciation,   96-104,    iio- 

114,  139 
as  liabilities,  123-126,  225,  330,  338 
for  maintenance,  96-104,  110-114,  139 
for  replacement,  96-104,  110-114,  139 
for  retirement,  96-98 

Gain  —  on  bonds,  173,  195-198 

of  capital,  90,  262 

non-operating,  90,  262 

(see  also  Revenue) 
Garbage  removal,  332,  333 
Gas,  332 

Goods  in  process  —  interest  cost  on, 
298 

profit  on,  307 

valuation  on,  306 
Goodwill  —  capitalization  based  on,  346- 
351 

determined  by  earning  capacity,  346- 

351,  405-407 
entries  for,  405-407 
Government  deposits,  250 
Grafters,  329 
Group  accounts,  314 
Gymnasia,  332 

Health  protection,  331, 333 
Heat,  as  burden,  278, 309 
Homes  (charity),  332 
Hospitals,  332 

Idle  time,  283-296, 312 
Impersonal  accounts,  defined,  22 
Impressed  system,  416 
Inactive  accounts,  254, 385 
Income  —  account,  93 

(see  also  Income  sheet) 

distribution  of,  on  bonds,  185-190 

gross,  defined,  226 

net,  defined,  226 

(see  also  Revenue) 
Income  sheet  —  defined,  84 

elucidated,  83-94,  226-229, 322-326 

fonn of,  91-94,  229,325 

as  indicating  value,  346 


Indexing,i7,  i9,35n,74n,75n,  76n,77n, 

258 
Indirect  expenses,  defined,  145 
Individual  ledger,  384-393 
Insane,  care  of,  332 
Insolvency,  with  excess  assets,  138 

(see  also  Bankruptcy) 
Installment  ledger,  398,  399 
Insurance  —  accounting  in,  263-269 

as  expense,  28,  54,  309 

policies  of,  264,  268 

premiiuns  for,  263-267 

(see  also  Five  elements) 
Interest  — account,  25,  33,   34,  42,   43, 

45,  49,  58,  407 

accrued,  42,  43,  45  n,  54,  192-194 

on  bills,  378,  379 

as  burden,  310 

compound,  159-162,  (formula)  421 

compounded  oftener  than  yearly,  169 

distinguished  from  discount,  25 

on  goods  in  process,  298 

on  goods  in  stock,  301 

method  of  entry  for,  26-28 

on  partners'  capital,  352 

proprietor's,  342-346 

pure,  343 

tables  for,  191  n 

waste,  341 

(see  also  Five  elements) 
Interest-accrued  account,  45  n,  192-197 
Interest-due  account,  45  n,  192-197,  258 
Interest-earned  account,  45  n,  192-197 
Intermediate  accounts,  314 
Internal  accounts,  21 
Interstate   Commerce   Commission,    ac- 
counting prescriptions,  143,  221,  224, 
226,  227,  228 
Inventory  —  account,  67,  92,  408 

applied  to  account,  30,  41,  I73-I7S» 
322-325 

taking  of,  117,  1 18-120,  272 

(see  also  Unexpired  items) 
Investments  account,  222,  255 
Invoice  book,  see  Purchase  Book 

Jails,  331  . 

Joint  cost,  illustrated,  141,  270 
Joint  products,  illustrated,  141 
Journal  —  bank,  387 

columnar,  59 

combined  with  day  book,  57,  58 

general,  64,  73 

old-fashioned  —  described,  18-20 
illustrated,  19,  33-34 

purchase,  375-378 

sales,  375,  378-380 

special  column,  59 
Journalization,  defined.  57 


442 


ACCOUNTS 


Labor  —  statistics  of,  317 

waste  of,  157 
(see  also  Wages) 
Lawful  money,  bank  holdings  of,  250 
Leases,  191 
Ledger  —  bank,  392 

bond,  192,  258 

closing  of,  45-51 

deposit,  384-390 

described,  17 

illustrated,  17,  34,  78-79 

indexing,  35  n 

individual,  384-393 

installment,  398,  399 

machine,  287 

mortgage,  258 

order,  275 

purchase,  67-68,  79,  375 

real  estate,  261 

sales,  67-68,  79 

stock,  375,  397 

stockholders',  397,  400 

stores,  271,  273 

tabular,  393,  394 

trust,  255-257,  260-262 

use  of,  17,  65 
Legal  evidence  —  cash  book  as,  71 

day  book  as,  16,  69 

ledger  as,  17 
Liabilities  —  capital,  221 

contingent,  121,  224,  333 

current,  138,  222 

preferred,  356,  357 

secured,  354-358 

statement  of,  40-43,  52,  84,  I37,  354" 
358 
Library  costs,  328,  332 
Life  interests,  distribution  of  income  for, 

185-190,  352 
Lighting  costs,  278,  309,  328,  332 
Lighting  plants,  332 
Liquidation  account,  358,  359 
Loading  —  insurance,  267 

railroad,  152,  154,  231-232 
Loans  —  by  banks,  249 

by  partners,  352 

(see  also  Bills  discounted) 
Locomotive  statistics,  156,  231-232 
Logarithms  for  interest  calciUations,  162, 

178 
Loose-leaf  systems,  413-414 
Loss  —  on  bonds,  173-175,  195-198 

of  capital,  90,  174-175,  402-403 

non-operating,  90,  1 74-1 75,  402-403 
Loss  and  gain  account,  12,  31,  48-56,  90- 
91,  123,  384,  407-409 

(see  also    Gain;    Income;  Loss;  Rev- 
enue) I 


Machine  cost,  279,  282 

(see  also  Machine-use  cost;  Rates,  mft* 
chine;  Rates,  minimum) 
Machine  ledger,  287 
Machine-use  cost,  276,  279,  282 

(see  also  Rates  additional) 
Machinery  —  account,  316 

costs  for,  276-296 

depreciation  of,  279,  282,  309,  317-322 

repairs  of,  273,  275,  279,  282,  290,  319 

(see  also  Machine  cost) 
Maintenance  —  accounts,  105-107,  143, 
147 

charges  for,  152,  233 

charging  to,  203-220 

defined,  103 

discussed,  98-99,  102-107,  219 

funds  for,  96-104,  110-114,  139 

as  method  of  treating  depreciation,  98- 

99 
Manufacturing  —  account,  273,  294,  295, 
296,  298,  306,  312,  324 

cost  of,  270-299 

income  sheet  for,  322-326 

profits  allowed  on,  300 
Margin  of  safety,  294 
Markets,  332 

Merchandise  —  account  —  interpretation 
of,  1 18-120 
use  of,  28,  30,  41,  48,  407-408 

in  branches,  126 

depreciation  of,  107,  120 

discount  related  to,   25,   70,  340-342, 
369-374 

inventory  of,  67,  407 

valuation  of,  118-119 

(see  also  Inventory) 
Militia,  331 
Minimum  rates,  288,  289,  291,  295,  296, 

.  310 
Mixed  train,  149 
Money  orders,  22 
Mortgage  bonds,  241 
Mortgage  notes  payable,  122 
Mortgages,  258 
Motive-power  accounts,  144 
Municipal    accounting  —  appropriations 
in,  334-335 

classifications  in,  330-333 

statistics  in,  329 
Museums,  332 

National  banking  law,  249,  251,  254  n 
National  Municipal  League,  330,  331 
Nominal  accounts  —  defined,  29-44 

elucidated,  83-92 
Northern  Pacific  R.R.,  233 
Notes,  see  Bank  notes,  Endorsed  note^ 
Promissory  notes 


INDEX 


443 


Obsolescence,  279,  282,  318 

(see  also  Depreciation) 
Ohio,  330 
Oil,  279,  311,  315 
Oncost,  see  Burden 
Operating  expenses,  defined,  226 
Operating  ratio,  226 
Operating  statement,  325 
Optional-redemption  bonds,  200-202 
Order  ledger,  275 
Order,  manufacturing,  271 
Original  documents,  books  as,  16 
Output,  estimated,  as  a  factor  in  burden 

distribution,  284,  290-294 
Overcapitalization,  211-220 
Overdrafts,  23,  386 
Overhead  cost,  see  Burden 

Parks,  332 

Partners  —  auditing  for,  365 

drawings  of,  352,  354 

interest  for,  352 

loans  of,  352 

salaries  of,  352 
Partnership  —  accoimts  for,  352-354 

agreements  in,  354 
Part  payments,  74  n,  77  n 
Passenger  statistics,  153 
Patterns,  299 
Pay  roll,  308,  314,  323 

(see  also  Wages) 
Personal  accounts,  defined,  22 
Petty  cash,  415-416 
Petty  items,  415-418 
Plant  —  account  interpreted,  109 

depreciation  of,  279,  282,  317-322 
Plant  repairs,  account,  275,  311,  314 
Play  grounds,  332 
Pledged  assets,  354-358 
Police  costs,  328,  331 
Policies,  see  Insurance 
Policy  loans,  269 
Postage,  28 
Posting  —  defined,  18 

process  of,  17 
Power  —  account,  311,  314,  315 

consumption  of,  157,  317 

cost  of,  280,  282,  284,  292-294 

economies  in  transmission  of,  158 

idle,  157,  284,  292-293 
Preferred  liabilities,  356,  357 
Premium  notes,  269 
Premium  on  stock,  123,  402 
Premium  surplus,  402 
Premiums  in  insurance,  263-267 
Prepaid  items,  see  Unexpired  items 
Present  worth  —  of  annuity,   166,  (for- 
mula) 426 

defined,  164 

of  principal  (formula),  420 


Primary  accounts,  314 

Prime  cost,  270 

Principal  —  amount  of  (formula),  419 

present  worth  of  (formula),  420 

required     to     attain     given     amount 
(formula),  420 

required    to    buy    annuity    (formula), 

.   42.8 
Prior-lien  bonds,  242 
Prisons,  331 

Profit  and  loss  account  —  interpretatioB 
of,  52,  123 

use  of,  12,  31,  48-56,  90-91,  384,  407- 
409 

(see  also  Gain;   Income;   Loss;  Rev- 
enue; Surplus  account) 
Promissory  notes,   see   Bills   receivable, 
Bills  payable,  Bills  discounted,  Bills 
protested 
Proof  —  of  journal,  36 

of  ledger,  36 

of  original  entries,  380,  394,  418 

of  receipts  and  expenditures,  131 

of  statement,  43 
Property  accounts,  defined,  11 
Proprietor's  account  —  closing  of,  48,  50 

as  external,  21 

profits  in,  56,  342-346 
Proprietorship  accounts,  55,  56 
Protection  (Ufe,  health,  property),  331 
Protested  bills  —  account,  122 

liability  for,  1 21-12  2 
Public  welfare  —  as  related  to  costs  and 
profits,  210-220 

in  municipal  accounting,  330,  331,  333 
Public  works,  332 
Purchase  account,  67,  92 
Purchase  book.  63,  65,  76,  369,  375-378 
Purchase  journal,  375-378 
Purchase  ledger,  67-68,  79,  375 

Railroad  accounts,  interpretation  of,  230- 

240 
Railroad  balance  sheet,  221-225 
Railroad  income  sheet,  226-229 
Railroad  statistics,  151-156,  231-234 
Rates  —  additional,  288,  289,  291,  295, 
296,  312 

machine,  281,  295,  296 

minimum,  288,  289,  291,  295,  296,  310 
Real  accounts  —  defined,  29,  44 

elucidated,  83-92 
Real  estate  account  —  interpretation  of, 
109 

typical  for  capital,  85 

use  of,  12.  41 
Real  estate  ledger,  261 
Realization  account,  358,  359 
Realization  and  liquidation,  3S8-36X 


444- 


ACCOUNTS 


Rebates  —  insurance,  268 

to  shippers,  as  assets,  238 
Receipts  —  analysis  of,  127-132 

classification  of  municipal,  330 
Recreation,  332 
Redemption  fund  —  as  reserve,  251 

required,  250 
Red-ink  items  explained,  49 
Reformatories,  331 
Register  —  accounts  payable,  376,  397 

accounts  receivable,  378,  397 

collateral,  258 

collection,  392 

comparative  cost,  275 

discount,  387-392 

vouchers  payable,  417-418 
Relief  (outdoor),  332 
Remainder-man,  185-190,  352 
Remodeling,  85 
Rent  —  economic,  277  n 

as  expense,  28,  308 

ground,  277,  282 

typical  for  revenue,  85 

unexpired,  54 
Reorganizations,  241-248 
Repairs  —  building,  290,  309 

as  a  method  of  treating  depreciation,  98 

distribution  of  cost  of,  290 

of  machinery,  273,  275,  279,  282,  290, 

319 
plant,  account,  275,  311,  314 
(see  also  Five  elements) 
Replacement    funds,    96-104,    iia-114, 

139 
(see  also  Five  elements) 
Reserve  —  bank,  249-252 
calculation  of,  431-434 
defined,  113 
life  insurance,  266,  269 
other  insurance,  269 
secret,  217,  228 
(see  also  Surplus) 
Reserve  accoimts,  loi,  102,  111-114,  125, 

220 
Reserve  fund,  no,  115 
Resources,  statement  of,   40-43,   52,   53, 

84,  137 
(see  also  Assets) 
Responsibility,   at  the  basis  of  all   ac- 
counting, 9- 11 
Retirement  funds,  96-98 
Revenue  —  charging  to,  defined,  85 
classes  of  municipal,  330 
nature  of,  83-92,  203-220 
proprietor's,  342-346 
statement  of,  40-43,  53,  84,  91-94,  226- 

229 

(see  also  Earnings;  Gain;  Income;  Loss 
and  Gain;  Profit  and  Loss) 


Risk  —  affecting  price  of  bonds,  183 

in  capitalization,  211 

proprietor's  compensation  for,  343-346 
Royalties,  191 

Safety,  margin  for,  294 

(see  also  Reserve) 
St.  Louis  &  San  Francisco  R.R.,  235,  236 
St.  Louis,  K.C.,  &  Colorado  R.R.,  236 
Salaries  —  of  partners,  352 

(see  also  Wages) 
Sales  account  —  factory,  306,  313,  322- 

324 

investment,  259 

mercantile,  67,  92 
Sales  book,  63,  65,  77,  369,  375,  378-380 
Sales  for  cash,  66,  74,  76,  77 
Sales  journal,  375,  378-380 
Sales  ledger,  67-68,  79 
Schools,  332 
Scrip  dividend,  140 
Secondary  costs,  298 
Secret  reserves,  217,  228 
Secured  liabilities,  354-358 
Selling  cost,  294,  299-302,  313 
Serial  bonds,  200 
Series,  solving  equations  in,  422 
Settlement  account,  359,  360,  361 
Sewers  and  sewage,  332,  333 
Shipments  account,  381 
Single  entry,  410-412 
Sinking  funds — for  amortisation,  185-190 

for  depreciation,  319,  321 

municipal,  335-339 

required  to  amotmt  to  given  simi  (for- 
mula), 428 

for  retirement  of  bond  premium,  178 

from  revenue,  123-126 

uncertainty  of,  187 
Snow  removal,  332 

Social  pofnt  of  view  —  in  capitalization, 
210-220 

in  municipal  accounts,  330,  331,  333 
"Soldiering"  detected,  157  ^ 
Solvency  —  balance  sheet  indication  of, 
52,132,222,237-240 

of  banks,  253 

bookkeeping  indication  of,  52,  53, 84 
Southern  Pacific  R.R.,  233 
Space  cost,  276-282,  297,  298,  301,  310 
Sprague,  Charles  E.,  191  n 
Statement  —  income,  91-94,  229,  325 

operaring,  325 

six-column,  —  described,  40-45 
elucidated,  53-54 
Statement  of  affairs,  354,  356-358 
Statement  of  financial  transactions,  127- 

132 
Stationery,  28 


INDEX 


44S 


Statistics  —  in  accounting,  151-158 

municipal,  329 

railroad  —  cost,  152,  156,  231-234 
freight,  154-155,  231-233 
loading,  152,  154,  231-232 
locomotive,  156,  231-232 
passenger,  153 
traffic,  151-155,  231-233 
Stock  —  discount  on,  403-405 

donations  of,  403-405 

premium  on,  123,  402 

in  treasury,  121,  404-405 

(see  also  Capital  stock) 
Stock  account,  306,  312,  324,  375,  377 

(see  also  Capital  stock  account;  Mer 
chandise) 
Stock  dividends,  140,  213-217 
Stock  holding  by  banks,  250 
Stock  ledger,  375,  397 
Stock  subscribed  account,  401 
Stock  subscriptions,  401 
Stock-taking,  see  Inventory 
Stock-watering,  140,  213-217 
Stockholders,  auditing  for,  364 
Stockholders'  ledger,  397,  400 
Storage,  as  burden,  297 
Stores  account,  271,  310,  322-324 
Stores-costs  account,  297,  298,  310 
Stores  ledger,  271,  273 
Streets,  332 

Subscriptions  to  stock,  401 
Summary-  of  financial  transactions,  127-132 
Sundries,  in  journal  entries,  19 
Superintendence,  as  burden,  279, 282,  291, 

297,  310 
Supplies  —  on  balance  sheet,  225 

statistics  of,  317 

valuation  of,  117 

(see  also  Stores  account) 
Surplus  —  account,  51,  84,  123 

on  balance  sheet,  84,  222 

bank,  250 

capital,  123,  175,  402 

donated,  404 

on  income  sheet,  84,  93,  94 

municipal,  333 

premium,  402 

for  the  year,  93,  94,  226 
Surrender  values,  267,  268 
Suspense  account,  224  n 

Tabular  ledger,  393,  394 
Taxes,  227,  309,  330 

(see  also  Five  elements;  Fixed  charges) 
Telegrams,  28 

Temporary  depreciation  account.  105-107 
Textile  costs,  303 
Ticklers,  259,  392,  397,  414 
Ton-miles,  154 


Tontine  policies,  268 
Tools,  279,  291,  296,  299 
Trading  account,  92,  93 

(see  also  Sales  account) 
Traffic  —  expenses  accounts,  144 

statistics  of,  151-155,  231-233 
Transportation  expenses  accounts,  144, 147 
Treasury  stock,  121,  404-405 
Trial  balance  —  errors  disclosed  by,  39 

errors  in,  38 

illustrated,  37,  80 

use  of,  36,  53 

value  of,  37,  39 
Trust  accounting,  255-262,  352 
Trust  ledger,  255-257,  260-262 
Trust  responsibility  shown,  257 

Ultimate  accounts,  314 

Undivided  profits  account — in  banks,  250 

use  of,  51,  123 
Unexpired  items  —  expense,  54 

insurance,  54 

interest,  42,  43-45,  52,  54 

rent,  54 
Union  Pacific  R.R.,  233 
Unissued  stock,  120,  401,  404 
United  States  bonds,  249 

Valuation — as  aim  of  accounting,  209-210 
principlesof,  118-120,173-175,203-220 
Voucher  book,  416 
Voucher  check,  417 
Voucher  register,  417-418 
Voucher  system,  416-418 
Vouchers  payable,  416-418 

Wages  —  account,  322,  323 

as  expense,  28 

of  general  officers,  298 

of  management,  proprietor's,  342-346 

(see  also  Labor;  Pay  roll) 
Wages  book,  274 
Waste  —  elements  of,  283 

elimination  of,  as  aim  of  accounting* 
283 

idle  time,  283-296,  312 

interest,  341 

labor,  157 

power,  157,  284,  292-293 
Wasting  assets,  96 
Water  costs,  328,  332 
Wharves,  332 

Where-got-gone  statement,  127-132 
Woods,  C.  E.,  156 

Work  in  process,  see  Goods  in  process 
Working  capital,  222 
"Writing  off,"  95  ^ 

(see  also  Depreciation) 
"Wriring  up,"  95,  173 


14  DAY  USE 

RETURN  TO  DESK  FROM  WHICH  BORROWED 

LOAN  DEPT. 

This  book  is  due  on  the  last  date  stamped  below, 
or  on  the  date  to  which  renewed.  Renewals  only: 

Tel.  No.  642-3405 
Renewals  may  be  made  4  days  prior  to  date  due. 
Renewed  books  are  subject  to  immediate  recalL 


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